Perpetual's Matthew Sherwood argues it is time for corporate Australia to deliver on the growth expectations that have supported share prices until now.
Investors would not mind seeing the equity returns in 2012 repeated in the current year, not least because markets still have to make up plenty of ground to reach pre-global financial crisis (GFC) heights.
But is the rally that started in mid-2012 sustainable? Are the same drivers still in play?
2012 – The year of valuation expansion
The majority of international share markets recorded strong gains in 2012; however this was primarily underpinned by higher valuations rather than any real improvement in the earnings performance of listed companies.
Indeed, higher valuations contributed more than half the price rise in 85 per cent of the world's largest 40 markets, and none of the 20 major markets saw a majority contribution from earnings growth (see Chart 1).
This trend has continued in early 2013, with higher valuations pushing many markets to fresh new highs powered by the 'January-effect', the avoidance of the US fiscal cliff, a clear easing in Eurozone stress, continued central bank largesse and further signs of improvement in both the US and Chinese economies.
Despite these strong rallies, the three-year side trend in the Australian and (ex-US) global share markets remains intact, and has only moved from the bottom of the trading range at end-2011 to the top of it in early-2013.
2013 – The rally needs earnings growth to continue
The rise in valuations has seen global price-to-earnings (P/E) ratios rally to a three-year peak. They are now around their long-term historic average, but this average is centred on a 30-year global leverage boom.
While the market is certainly not expensive, valuations may struggle to lift much from here – and for the recent market rally to continue, investors need earnings growth to come through.
This is evident globally, as well as in Australia, and while the 2013 US and Chinese economic outlook is improving, the slowing Australian economy is making domestic earnings delivery more arduous.
Even though Australian earnings downgrades have recently stabilised, the market is unlikely to be entering a sustained upgrade cycle, other than those related to the price of iron ore (up 40 per cent since September 2012) and the aforementioned improvements in the world's two largest economies.
Hence, there will be increasing top-line revenue pressure on corporate earnings in 2013, and the Reserve Bank of Australia (RBA) needs to aggressively cut interest rates to support asset prices (both housing and shares) or risk a further weakening of the Australian economic outlook.
Australia's economic advantage is almost gone
For 10 years, Australia has been riding the coat-tails of China through high commodity prices and a record mining investment boom (which shielded Australia from the worst of the post-GFC impact).
This boom will peak within a few months and then begin to deflate, pulling growth down in the process.
With the Australian Government pursuing austerity, the entire policy response now falls on the RBA, which has been reducing official interest rates for 15 months to stimulate the non-mining economy.
However, in a deleveraging environment monetary policy is less powerful and not the panacea it once was, as most economic sectors are more focused on reducing debt than increasing spending.
Indeed, despite a record low cash rate, economic measures including retail sales, housing finance, credit growth, job ads and payrolls growth continue to underperform market expectations – and several stocks priced for earnings growth in 2013 will struggle to achieve it.
Implication for investors
In 2012, Australian earnings growth turned negative and corporations had to increase their payout ratios to support returns, which will be harder to do in 2013.
A subdued global climate with modest earnings growth (at best) and share market valuations around leverage-boom averages suggests price gains are likely to be modest.
Income and yields are likely to be key drivers of share performance, particularly with real deposit rates likely to turn negative in late-2013.
Cash may have served investors well in the past five years. But the cash king is dead and we are now hoping to hail a new king, provided he delivers returns in one form or another, but most likely through income/yield.
Importantly, 2013 will witness a constant battle between the interest rates bulls and domestic economy bears: this environment is likely to produce a mixed investment performance and is ideal for skilled stock pickers.
Indeed, a focus on companies with strong balance sheets, a dominant market position, good cost control and those that have sustainable margins is likely to reward investors.
Consequently, 2013 is shaping up just like it did in early 2012, the only difference being that valuations are no longer cheap.
As such, earnings growth is coming to the fore – and investing in quality companies that have the aforementioned attributes should allow investors to experience any upside potential with downside protection.
Matthew Sherwood is the head of investment market research at Perpetual Investments.
