Feature Stories | Dec 19 2019
This article was first published for subscribers on December 12 and is now open for general readership.
The Australian stock market looks set to begin 2020 on from an overvalued position, making gains in the year hard to come by.
-PE multiples stretched
-More RBA easing anticipated
-Fiscal support essential
-Equities still the place to be
By Greg Peel
At the end of November, notes Macquarie, ASX stocks, ex-resources, were trading at a forward PE of 19.2x, close to the highest level since 1960.
In other words, investors were prepared to pay an average of 19.2x the earnings consensus analyst forecasts estimated for the year FY20 in valuing a stock.
If banks, insurance companies and REITs are excluded as well as resources, that figure rises to 23.6x.
Now, it must be acknowledged that in two days in early December the ASX200 lost close to -300 points, which would have trimmed those price/earnings numbers somewhat, but the index has since recovered around half of that loss and, whichever way you look at it, Australian stocks are expensive on an historical basis.
Why? If anything, the Australian economy looks to be in dire straits. The RBA would not have cut three times since June and pre-warned that QE may yet be on the cards if the Australian economy was looking rosy, which is what historically high PEs imply.
The two are of course inexorably linked – PE multiples and the RBA cash rate. Low rates have sent investors on a desperate search for yield, and in the current environment, which has fixed income investment, from cash right out to ten-year government bonds, lower than the inflation rate, equities remain the only option for fund managers and retail investors.
One interesting point to note is that lower interest rate also implies a lower “risk free rate” which stock analysts plug into their valuation models. A “risk free rate” is used to value equities on the basis if an investor can achieve this return risk-free, then risky equity returns must at the very least exceed this return before they are of value in their own right. The “risk free rate” is used to discount future cash flow (earnings) forecasts back to today’s dollars, providing an implied share price valuation.
The lower the risk free rate, the higher the valuation, all else being equal. Thus it follows that the higher the earnings forecast, the lower the price to earnings ratio, all else being equal. Yet as Macquarie, for one, points out, PEs are historically high.
Enter Tina. This lady has been having a substantial influence on global stock markets since the GFC, but now, as central banks go back into further easing mode, she has really hit her straps. Why invest in risky equities? There is no alternative (TINA). With no alternative, investors have to pay up to be involved, hence historically high PEs.
A One-Stop Shop
In days of yore, Australian banks were considered to be defensive. Yore, of course, being pre-GFC.
They were defensive because, while they were exposed to economic cycles, they paid a solid yield on the money they made from simply borrowing at a lower rate than they lent at. And everyone needed a bank.
For the same reason, the likes of consumer staples, teclos and healthcare were defensives, paying unspectacular but reliable yields on the basis that everyone must eat, make phone calls and get sick occasionally. Better yields were paid by the likes of utilities and REITs, but capital gains were of the slow moving variety. Yes – once upon a time property values moved slowly. Ask Grandpa.
On the other hand, if you were looking for capital gain at the expense of yield, you’d hit the resources sector. Miners and oil & gas companies paid little to no yield but could (think the noughties commodities “super-cycle”), bring stunning capital gains.
Fast forward to today and the lines between cyclical and defensive, growth and yield, are blurred. Banks have become high risk, healthcare is now a growth story, telcos have become increasingly “disrupted”, REITs are beholden to fast-moving property values, and miners are paying out unheard of riches through dividends.
What does tie the Australian market together nonetheless, on a sector to sector basis, is yield. Everyone is paying dividends, other than growth-phase high tech companies, resource sector explorer/developers, and companies in trouble commercially. Low interest rates are providing scope to pay dividends, and demand for dividends is forcing boardroom decisions.
And that makes the little ol’ Australian market very attractive to the rest of the world. Particularly the US, where investors dream of a yield of 2%. But being, by Wall Street standards, a small market, it appears Australia is being increasingly viewed as singular equity asset.
And why not? You only need buy the ASX top 20 companies and you have over 80% of the ASX200 market cap. Expand your horizons a bit and you’re well over 90% before you’ve hit the ASX100. It was very notable in early December that when Wall Street swooned on negative trade news, investors sold cyclicals and rushed into defensives. When trade news turned positive, they rushed into cyclicals and sold off defensives.
Over the same period, everything in the Australian market was sold and then everything was bought again. No distinction. Australia is a singular asset.
So with that in mind, what are the prospects for this singular asset in 2020?
The Free Put
“Perhaps one of the clearest outcomes of recent [global] monetary policy,” writes Tamim Asset Management, “is the premium valuations we have been seeing across the equites”.
The possible exception is the eurozone, where bond valuations have ruled over equity valuations, but the theme has extended to emerging markets including India and China. Domestically, notes Tamim, it has been seen most recently in the RBA’s lowering of rates this year, with another cut expected early next year and the possibility of QE coming into play.
More and more, central banks are shifting away from the traditional mandate of inflation management towards GDP targeting, in the absence of clear fiscal policy.
And this is not just an observation for Australia.
The US Federal Reserve got the fright of its life this time last year when its aggressively hawkish policy under new chair Jerome Powell sparked a near stock market crash. The Fed then famously “pivoted”, stocks took off, and after three rate cuts this year, the S&P500 has marked ever higher all-time highs.
The Fed has been forced to act in absence of any fiscal stimulus from Donald Trump since the tax cuts of 2017. Indeed, forced to act to offset Trump’s fiscally negative trade war(s).
In the eurozone, a decade of Germany-enforced austerity upon members in the wake of the GFC has left the ECB carrying the can, all the way to negative cash rates and further QE. Only now is Germany talking possible fiscal stimulus.
Cash rates are also negative in Japan, where the government’s sales tax (think GST) increases are also providing a fiscal drag.
And of course in Australia, budget surpluses win elections. Maybe 2020 will be the year the government realises recessions don’t.
But before that epiphany, it’s all been up to the RBA.
The concerning thing about central banks shifting focus to GDP support, suggest Tamim, is an increasing tendency of markets globally to assume the notion of a “central bank put”.
A “put option” is the right but not the obligation to sell at a predetermined price and is used as a downside hedge by investors, providing a guaranteed exit of positions before things really get ugly. A “central bank put” is the implication that if markets begin to get ugly, such as this time last year, the central bank will step in with further policy measures and right the ship.
For stock market valuations to be historically elevated at a time of constant recession talk, investors must feel comfortable with the risk. The cycle becomes somewhat self-fulfilling, which is why Tamim Asset Management cannot see global monetary policy reverting back to “any semblance of historical normality” in at least the next five years.
Hence, says Tamim, “it makes no sense to stay away from equities for the foreseeable future”. The result of near-zero rates is companies with higher debt levels are enjoying greater upside leverage. This does not means investors should pile into debt-laden “zombies”, but at the very least the “central bank put” should ensure equity valuations track sideways as a worst case scenario.
By the same argument, gold becomes ever more attractive as a long term hedge.
It is Tamim’s opinion, and the asset manager is hardly alone, that the so-called “phase one” trade deal between the US and China will be the first in a series that will be limited, at least in the initial stages, to public stage shows, as the US election approaches. “It is unlikely that anything substantive is reached”.
“This is a game of individuals rather than rational statecraft”.
Moreover, Tamim suggests that one of the often overlooked issues is that of currency. Trump’s tariffs are curtailed by the almost immediate effect on the dollar/renminbi exchange rate, such that the impact is absorbed by devaluation.
What will increasing be prominent over the coming years, Tamim speculates, will be the propensity of Chinese corporates to take increasingly large stakes in firms in South East and Central Asia in the search for the next growth markets. Unlike The West, China’s move towards de-industrialisation will be undertaken is a much more schematic and coordinated manner.
China will thus move up the value chain, as did Japan in the seventies and eighties, as it looks to outsource labour-intensive processes to the likes of Vietnam and Thailand. This, asserts Tamim, is one of the key premises behind One Belt, One Road.
All of which suggests China is in no hurry to capitulate to the US on the matter of trade, despite Trump’s assertion’s Beijing is desperate to make a deal, and will likely string out negotiations for long enough to wear the White House down.
It’s doing a pretty good job so far.
None of which sounds promising for Australia, except that Tamim believes it actually puts Australian investors in a “uniquely advantageous” position.
The Aussie dollar’s reliance on commodity prices makes Australian companies with exposures to China and South East Asia an interesting play. The currency acts as a natural hedge for international exposure that should allow access to growth markets across the region and allow companies to take advantage of the recalibration of supply chains.
The Stock Market
The outlook for the ASX200 in 2020 clearly depends on its starting point. As is stands you may be reading this article already having a clear idea of where 2020 will begin, if there is a pertinent announcement with regard US-China trade before this article goes to print.
But assuming that is not the case, we might consider there are four paths to to the end of 2019 – very good, good, bad and very bad.
China might sign a trade deal before this weekend, however minor, leading to at least the withdrawal of Trump’s last tranche of tariffs. Very good.
With a deal not yet signed but getting “close”, Trump may extend the tariff deadline into 2020. Good.
With a deal not yet signed, the tariffs may go ahead. Bad.
China may suddenly walk away, as has happened before, and there is, for now, no deal. More and larger tariffs. Very bad.
For the sake of argument, we’ll assume the Australian market enters 2020 with similarly elevated PE multiples as is currently the case. (Noted at the top).
Credit Suisse has set a target for the index of 7000 in 2020, implying 4% upside.
The analysts foresee and earnings recovery but a reduction in those overstretched multiples. “We think more income than capital growth,” they say.
Credit Suisse is expecting an earnings recovery based on a global cycle catching up with the resilient US consumer, as “uncertainty fades”. [Insert preferred uncertainty here].
The analysts see the recent surge in Australian housing, which has caught most by surprise, as foreign-driven (Hong Kong would be one culprit), but can see a broadening out to include more domestic demand enabling easier financial conditions to lift credit growth. If not, Credit Suisse at least sees fiscal and mining spending kicking in the shore up the cycle at some point.
Morgans notes that beyond house prices, recent Australian economic data have been disappointing, particularly with regard retail sales and jobs growth. The analysts suggest, as a best interpretation of mixed data, that the Australian economy is probably in better shape than the press perhaps indicates, but that we can expect more of the same sluggish activity as a base case.
It is recent hope around a trade resolution (if only partial) that has driven the stretching of PE multiples, Morgans believes, when profit FY19 growth for the ASX200 ex-resources was only 1%. The very mixed AGM season that followed FY19 results, crystallising further downgrades, suggests we may see profits fall for this group in FY20.
This would reflect not only a challenging economy, but also bank remediation actions.
An improvement in investor sentiment is occurring globally, Morgans notes, and further cuts from the RBA may help sustain Australian shares near record highs, but the analysts see the material risk of an eventual disconnect between ever higher equity prices and the earnings results companies achieve at the February result season.
Morgan Stanley, too, is wary of earnings. Its target for the ASX200 in 2020 is 6700, which is about where it is now.
The problem for Morgan Stanley is, again, that PE multiples are already stretched. The analysts expect the current earnings cycle to trough in the March quarter as the economy remains subdued through the first half 2020, as stimulus provided by the RBA (rate cuts) and government (tax cuts) to date continues to be dampened by persistent household deleveraging.
By deleveraging we can assume households paying down debt, via reducing credit card balances, via not reducing mortgage payments despite lower obligations, thus speeding up ultimate repayment, and also cutting back on discretionary spending, including in this Christmas to come.
All year we have been told we have the most heavily indebted households in the world. All year we have heard the word “recession” bandied about. The RBA has given us the gift of resolution, not of stimulus.
That said, Morgan Stanley, and most everyone else, expects the RBA to cut again in February. Morgan Stanley is also amongst the majority in expecting the May budget to bring round two of Morrison’s tax cuts. Together these should lead to a modest recovery through the second half of 2020 and into 2021.
All bets are off, however, if the government doesn’t do its bit.
Morgan Stanley reaches its 6700 target on a combination of 6% earnings growth, balanced out by a drop in PE multiple back to 16x.
The implication here, and the reason why Morgan Stanley effectively forecasts the ASX200 to tread water, is that earnings have to improve simply to justify current PE multiples, meaning signs of earnings improvement will only confirm, not improve, share prices.
Downside exists if further stimulus in 2020 fails to shake households out of their deleveraging obsession.
Morgan Stanley summarises the outlook for Australia in general in 2020 down to five key themes.
Let’s take the last one first: trade. I think we’ve got that covered.
The first is the “shape and efficacy” of 2020 stimulus. While the RBA is widely expected to cut in February, less certain is a pull-forward of Morrison’s round two tax cuts into the May budget. If the government can indeed see the light, then the RBA can go on hold for an extended period and avoid QE.
If not, well…
The second is the timing and pace of a subsequent rebound in earnings, if that is to be the case. The third is linked to the second, that is a focus on where “value rotation makes sense in an Australian context”.
In a traditional market, “value” stocks are those that have become cheap due to pervading economic conditions, thus offering risk/reward “value” when conditions improve. The opposite is “growth” stocks, which have outperformed despite economic conditions on the basis of future potential.
Typically, value stocks are the ones that pay nice dividends, while growth stocks do not.
But the value-growth argument, and the cyclical-defensive argument, have become blurred in today’s context, as I have alluded to earlier in this article with regard yield. A turn in economic conditions, and thus corporate earnings, is when value stocks should come to the fore, funded by selling growth stocks, but as Morgan Stanley suggests, the focus should be on “where value rotation makes sense”.
Morgan Stanley’s fourth key theme relates to “the signals from housing-linked sectors”.
The analysts expect the recovery in house prices to continue but the pace to slow by early 2020 as turnover picks up and tighter credit conditions, as driven by the bank Royal Commission, begin to bite. Construction nevertheless lags prices, given the lengthy process of planning, building approval, financing and ultimate shovels in the ground, thus construction should continue to fall into early 2021, weighing on jobs growth.
But by 2021 the housing market will be in undersupply, Morgan Stanley suggests, and declining vacancies, rising rents and still-low interest rates will see price growth re-accelerate.
So if all goes to plan, requiring no trade war escalation and a Morrison government prepared to pull its weight, the Australian economy should turn around quietly in 2020 before looking more healthy in 2021.
The Australian stock market is nevertheless not, as a whole, offering much in the way of upside given already stretched valuations. This means investors must choose wisely.
But don’t forget, central banks have our back.
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