Are Australian equities returning to form?

With term deposit rates falling and bond yields at historic lows, investors are finally ready to listen. Janine Mace reports things are looking good for the Australian equities sector.

For a few weeks there in January and February it seemed the bulls were waking from their long siesta as the Australian share market experienced a long-overdue rally.  

After a shaky start, the S&P/ASX200 All Australian Accumulation Index returned 20 per cent over the calendar year, and February saw it finally break the psychologically important 5000 mark for a sustained trading period. 

Although the bears were soon in charge again, many investors took note and wondered for the first time in a long while if the dark days were over.  

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It didn’t take long for local equity managers to be out spruiking their wares and talking up the prospects for a strong rally.

And this time around investors are in the mood to listen – particularly with cash and term deposit rates falling and bond yields at historic lows. 

It sounds like just the scenario for a return to the good old days for Australian equities.  

According to AMP’s head of retail, Craig Keary, people are taking notice of the positive headlines. “It is starting to build momentum. It appears the market has turned and people are getting more confidence,” he says. 

“Our house view is optimistic about the outlook for Australian equities, as we are seeing improvements in the economy and the world outlook, so the Australian market is poised to deliver a good performance.” 

Platypus Asset Management chief investment officer, Donald Williams, is also cheerful. “I think we are at the start of a new bull market.” 

Improved conditions overseas are helping, with market optimism spreading despite the overhang of problems in Europe and the US. In fact, the Australian market has been late to the party, with the US outperforming expectations for much of 2012. 

“We have seen good performance by equity markets in the last six months globally,” notes Jonathan Armitage, MLC’s acting CIO and head of equities. This is encouraging a change in sentiment.  

“Market performance encourages additional investment by retail investors and advisers, explains Morningstar’s head of equity research, Andrew Doherty. 

Out with bonds? 

The optimism is being further boosted by talk of the start of a ‘great rotation’ from bonds into equities and the potential end of the so-called ‘bond bubble’. 

San Francisco-based Russ Koesterich, BlackRock’s global chief investment strategist, made this point during a recent visit.

“Money is seeping out of cash and other safe harbours as investors unshackle the chains of nervousness. Fear is down and greed is up.” 

In Australia, the money flowing into the equity market seems to be coming from the huge pool of investor money sitting in term deposits. 

“Despite talk of increased rotation, we are not seeing significant selling of bonds and it seems recently the money moving into equities is from cash, not fixed interest,” Armitage says.  

Doherty agrees investors are less interested in fixed interest as “they feel they were overweight bonds and fixed interest and underweight equities. It has been an asset allocation shift pushing the market up.” 

The end of the golden era for cash in Australia may be at hand, Williams notes. “The recent rally has been domestically-driven, with some institutional reweighing into equities occurring last year.” 

Looking good – maybe 

Although equity markets have rallied strongly, some experts remain circumspect and point to the potential for it all to end in tears - yet again. 

According to Montreal-based Frederic Imbeault, vice-president Asian Markets at Hexquest, sentiment is running high in many equity markets and Australia is no exception.  

“There is a lot of positive expectations and overestimations of values in the market,” he notes. 

“A lot of positives are priced into the market and there is a lot of complacency. However, a lot of economic headwinds still remain, especially in the US.” 

Imbeault believes the market may yet surprise those who are feeling bullish. 

“We could end up in the same mini-cycle as over the past three years, with a decline over summer, policy action in the autumn and an upswing towards the end of the year.” 

Koesterich agrees, particularly in relation to the US market. “We have sort of been here before. The start of 2011 looked very similar. Correlations were similar - but risk appetite was greater. That year did not end well for risk assets.” 

Doherty is also cautious. “The Australian market is not trading on fundamentals. Investor confidence has shifted but the economic realities have not changed, as there is still high household debt levels and high labour rates. We are seeing project costs blow out and slow global growth,” he says. 

“We think recently investors have not focused so much on global economic problems so much as on yield.” 

The reduced anxiety and search for income have seen the local market rally strongly since mid-2012, making value increasingly hard to find.   

In early March, Morningstar’s recommendations on Australian equities were split 3 per cent buy, 7 per cent sell, 10 per cent accumulate, 54 per cent hold and 26 per cent reduce. 

“It is getting harder for investors to get good value in the market. We don’t have too many ‘buys’ and have more ‘reduces’ and lots of ‘hold’ recommends. That means positive returns can be achieved, but it is increasingly difficult,” Doherty explains. 

Imbeault agrees risks remain. “Advisers need to try to price risk as well as the good news, as we feel the market is cued to good news and being prudent is wise at the moment.” 

Earnings key to progress 

Another weight on the local market is ongoing concern around earnings. 

A recent paper by State Street Global Advisors head of active Australian equities, Olivia Engel, noted trailing earnings per share (EPS) dropped 40 per cent from their high during the GFC.

“2010 and 2011 saw an increase in earnings from the lows of the financial crisis, but this was mostly driven by an unsustainable source – cost cutting, not growth. In 2012, EPS dropped around 10 per cent, while dividends per share (DPS) stayed roughly the same.” 

Williams believes renewed earnings growth is essential for the market to progress much further, with the recent rally largely valuation-driven. 

“The key thing holding back the Australian equity market is a lack of profit growth, and this seems to be coming back in this profit season. It is still early, but it looks like the seeds of a recovery in profit growth are appearing.” 

Armitage agrees: “In Australia, earnings growth was only 1-2 per cent last year, but for the market to rally strongly, it will need earnings growth to continue. A lot depends on earning growth coming through, but if we see better Chinese growth and robust commodity prices, the market will continue to improve.” 

Imbeault believes the recent rally is not necessarily a vote of confidence in Australian shares – and companies need to continue improving their performance.  

“The last rally was a strange one, as it came on the back of deteriorating economic conditions and so-so earnings growth. Most of the rally was a price-to-earning ratio [PE] re-rating phase, as market expectations are better for a global outlook. However, this is not necessarily on solid ground,” he argues. 

“The Australian equities market is getting too pricey as economic growth may not deliver what analysts are expecting, so it could disappoint in the next six months or so.” 

Attractive - on a relative basis 

Much of the renewed optimism about Australian equities is founded on the relatively positive outlook for the local economy compared to those in other developed markets. 

According to Koesterich, Australia is currently viewed as a favourable investment destination. “Long-term it is seen as favourable, and you can see this through the Australian dollar.

Australia has a low government deficit and a funded pensions system, so it is viewed among developed markets as a safe haven.”  

Imbeault agrees the local market is appealing on a relative basis, even though Australian shares are not cheap.

“We have a slight preference for Australian equities. Even though the market is priced a bit high and the economy is declining, it is still a lot better than elsewhere.” 

The potential payout rates are also attractive.

“Australian companies also have high payout ratios of 7-8 per cent, which is pretty rare in the world. Foreign money will chase bonds rather than equities, but those that do are looking for dividends,” Imbeault says. 

In a world where investors are looking for a safe place to park their money, the economic stabilisers embedded in the Australian economy are also attractive. 

“Australia has a lot of ammunition if conditions decline, as it can cut interest rates. It has got fiscal room to move and there are a lot of variable-rate mortgages, so any stimulus moves into the economy quickly,” he notes. 

Investors take a look 

With the sharemarket continuing to perform, retail investors appear to be finally starting to turn their attention away from cash.  

“We are starting to see the green shoots of investors being increasingly favourably disposed to Australian equities, but we have not seen a significant shift yet. There is a lot more talk than action at this stage,” Armitage says. 

Doherty agrees the tide is slowly turning and believes there is increased interest in the sharemarket compared to mid last year. Trading volumes since December have risen and are two to three times what they were in the recent past.” 

Williams feels the mood has changed, but believes there is a way to go yet when it comes to investor willingness to commit to the sharemarket.  

“The majority of advisers have been very positively predisposed to the Australian equity market and have been recommending to their clients to increase their exposure to Australian equities from cash, but clients have been reluctant to do so,” he says.  

“The recent rally will help to change sentiment, especially if the market can stay over 5000 for several weeks, as it will convince investors the worst is over.” 

In Keary’s view, advisers are increasingly keen to move clients out of the perceived security of term deposits with declining rates and into rising equity markets. 

“We are seeing that financial planners want information and tools to have those conversations with clients. As financial planners are doing reviews, they are explaining the benefits of moving dollars out of cash,” he says. 

Williams believes there are some key messages advisers should be delivering to clients about looking at the current rally in its historical context.

“We are a long way from the 2007 high and if we have two to three years of double digit growth, I would not be surprised. Being underweight in Australian equities is more dangerous at the moment than being overweight.” 

For Keary, the message to clients should not just be about the potential for growth, but also about the potential for higher income.

“We are seeing increased discussions about investing in Australian equities for income, not growth. Australian equities can deliver income, which is an attractive message for both investors and advisers. 

He feels clients need to recognise that equities can play a dual role in a portfolio and can provide a better final income result.

“There are other sources of income than fixed interest-style products.” 

AMP recently launched an adviser website discussing the income alternatives to cash, and Keary says the feedback so far has been very good.

“Planners are now having these conversations with clients, and the feedback we have had is that these conversations are being well received.” 

Words of warning 

Although advisers may find clients are finally willing to dip their toes back into the equities market once again, it may yet prove to be another false dawn, with many experts urging care. 

“There is a risk that investors are piling into the market at the top of the curve. There is not as much value there anymore. We are not scared, but investors should be increasingly wary and focus on value and buying undervalued businesses,” Doherty cautions. 

Advisers and clients need to be realistic, he says. “Investors should lessen their return expectations for the equity market. It is hard to expect 20 per cent again over the next year. 

“Decent returns can be generated, but the focus needs to remain on value and quality. Investors need to ensure they have access to high-quality information and resources. Advisers need to be prepared to do thorough analysis or outsource it to specialists,” Doherty urges. 

Keary agrees investors need to maintain a ‘safety first’ approach. “Advisers should continue to focus on companies with reasonable earnings growth and strong franchises - those that will be less buffeted by external events.”