The Australian economy grew strongly over the June quarter recording an increase of 1.2%. March quarter growth was very much dominated by the public sector as private sector demand actually detracted from growth, albeit slightly. The challenge in the June quarter was always going to be whether or not private sector demand could improve sufficiently enough to withstand the gradual withdrawal of stimulus measures. And indeed it has. Household consumption expenditure increased by 1.6% but importantly was driven largely by vehicle purchases (up 11.2%) and discretionary recreation spending (up 3.3%). Large purchases such as vehicles are typically only made when individuals feel confident about their financial prospects and so is a very positive indicator. Private dwelling construction also showed solid improvements.
Despite higher interest rates, discretionary spending continues to gather momentum, a by-product of high levels of consumer confidence underpinned by very low unemployment and disposable incomes that have been assisted by rising asset prices (property prices more so than shares; according to RP Data-Rismark, national housing prices in capital cities rose by 12.2% in the year to 30 June).
Of course, it would be remiss of us not to mention the contribution from the mining sector. The inexorable rise in commodity prices and resources volumes led to the largest trade surplus since 1973. Moreover, mining and energy sector construction and investment intentions remain high. The $43 billion Gorgon LNG project has just begun and new LNG projects on the North West Shelf off the coast of Western Australia and coal seam methane projects in Queensland are in the advanced stages of planning.
Outside the mining sector though, conditions among different business sectors are more varied. Exporters have been hampered by the strong Australian dollar. Commercial construction, outside the school building projects, remains weak due to ongoing funding constraints. Some retailers also continue to report mediocre conditions despite the improvement in retail sales in recent months. Excluding the mining sector, company profits rose 3.39% in the June quarter overall.
Since the release of the June accounts, economic data has remained broadly positive:
- Retail sales rose by 0.7% in July (on top of the 0.8% rise in the June quarter)
- The unemployment rate fell to 5.2% as more jobs were added in August.
- Building approvals rose 2.3% in July.
- Housing credit rose by 0.5% in July while business credit fell by 0.4%.
- The WMI Consumer confidence index rose by 5.4% in August to be back to the same level experienced at the start of the year.
- The NAB Business conditions index rose from two points in July to 11 points in August, the highest level in 4 months.
The high level of investment and construction in the mining and energy sectors is likely to continue to lead to further growth in coming quarters. At the same time, the allocation of resources (labour and capital) to those sectors continues to add to capacity constraints and adds to the risk of growing inflationary pressures. To date the impact of rising interest rates on consumer spending has been offset by a strong labour market (that has supported incomes) and rising asset prices (house prices). This may be tested in coming quarters if the recovery gains more momentum as the risk of further interest rate rises, failing any global slowdown, is likely to increase. As household debt remains high, further interest rate rises are likely to have a moderating impact on consumer demand. That being the case, further growth will be more dependent on the business sector, which outside the mining sector, remains less robust. In our view these counterbalancing factors are likely to moderate growth in 2011 back to trend levels. The ongoing uncertainty about the strength of the global recovery, which will be discussed below, remains the key risk to this forecast.
Economics is often referred to as the "dismal science". The reference is to the fact that, unlike science or maths, there is no absolute proof in economics. In other words, a range of economists presented with the same data can arrive at completely different conclusions. No more evident has this fact been than now. Some economists continue to believe that a "V' shaped recovery remains probable, others a "U" shaped and still others a 'W" shape more indicative of a double dip recession.
To highlight the point, investors who subscribe to the "V" shaped recovery have pointed to the strong rebound in Industrial Production, as highlighted in the graph below:
The chart above shows US industrial production as a percentage change over the corresponding period of the previous year (e.g. change from Q1 2009 to Q1 2010, and so on). There is no question that this chart lends powerful support to the "V" shaped argument. Yet when the same data is analysed in a different way, on a month on month basis rather than against the corresponding quarter in the prior year, the chart starts to look a lot different as follows:
While a rebound in activity is still evident, the level of outright activity remains well below the peak periods experienced before the GFC. Further, and more importantly, the rate of change in recent months has begun to ease which is consistent with our hypothesis that growth in the United States throughout the latter part of the year will begin to slow for the following reasons:
- Many fiscal stimulus measures have expired (first home buyers tax credit, investment tax credit, cash for clunkers and cash for green appliances).
- Given the large public debt, support for more stimulus from Congress is waning.
- While the US central bank (the Federal Reserve) continues to suggest that it is ready to add more support to the economy we fail to see what more it can do. Measures to stimulate borrowing including very low interest rates and Quantitative Easing are having little or no effect. Households remain heavily indebted and reluctant to borrow, especially when asset prices remain fragile and the economic outlook remains weak. Similarly, businesses are unlikely to borrow unless demand prospects improve.
- Unemployment remains stubbornly high. While the official unemployment (U-3 measure) stands at 9.6%, the U-6 measure (which includes those that have stopped looking for work and those that work part time but would like to work full-time) stands at 16.7%.
Outside the United States, the problems in the Eurozone have been well documented. Sovereign debt problems remain large and perilous. The resultant fiscal austerity measures will inevitably detract from growth for some time. Despite this, output growth surprised on the upside in the June quarter, with German growth particularly firm. This is perhaps difficult to reconcile but is more than likely a case of the production of pre-existing orders that emerged after the depths of the GFC, and the by-product of a much weaker Euro, rather than indicative of any sustained strength. Indeed Germany's private sector expanded at a much slower pace in August and the latest euro-zone PMI data suggests the area's economy is beginning to slow down.
Fortunately activity in China remains strong and has supported growth for key trading partners, including Australia. Despite some recent moderation in manufacturing data, growth in household consumption and infrastructure spending has remained exceptionally robust. But we do not subscribe to the desynchronisation theory and so suggest that external demand in China is still likely to slow towards the end of this year in line with our view of more subdued growth in the US and the Eurozone. This implies that growth in China may slow from 10%+ to a still solid 8% or so.
In summary, expectations of a V shaped recovery remain far too optimistic. The underlying cause of the GFC – too much debt in much of the developed world - remains largely unaddressed. While it is true that corporate sector debt has been reduced, much of this has been at the expense of existing shareholders (rights issues to reduce debt that have caused dilution and much lower share prices) and taxpayers (bailouts which, together with stimulus measures, have escalated government debt). But deleveraging in the household and public sectors remains a daunting task and one that will take many years. Execution risks remain high.
Over the quarter ending 30 September 2010, the ASX 200 Accumulation Index rose by 8.04%.
The August reporting season contained few surprises with June half profit results broadly in line with market expectations. Coca Cola, Transurban, Newcrest and Woolworths were key outperformers in our recommended portfolio while Telstra was a notable underperformer. Yet the strong economic data was somewhat at odds with the more measured outlook statements that prompted expected earnings for FY10/11 to be downgraded by almost 4%.
Consensus analyst earnings forecasts for the 2010/11 financial year have been downgraded slightly to around 21%. The resource sector is expecting earnings growth in the order of 46% while industrials are expecting a more modest 13% growth. Based on these forecasts, our fair value assessment for the ASX 200 as at 30 June 2011 would be in the order of 5584, an increase of almost 22%. Other valuation indicators would seem to support this view (the 1 year forward Price/earnings ratio stands at around 12, well below its low inflationary average of just over 14; the 10 year bond yield is well below the earnings yield; the forecast dividend yield is above long term trends).
Valuation metrics indicate that the Australian sharemarket is significantly undervalued. Given the relatively strong domestic economy, and the strong historical correlation between earnings growth and sharemarket returns, the potential for the sharemarket to move considerably higher over the next 12 months remains high. Historically, valuation gaps of this nature tend to provide compelling opportunities for long term investors. Yet risk aversion is perhaps understandable given the economic challenges that much of the developed world now face (elevated public and household debt concerns).
It is clear that domestic growth would have to slow sharply to justify the muted level of future earnings embedded into current share prices. While this could indeed occur should the US fall back into recession, the probability of such an outcome needs to be put in context (in our view, a 30% chance). We recommend a neutral exposure to Australian shares over coming months.
The MSCI World (ex Australia) Index rose by 8.87% over the quarter ending 30 September 2010.
Global sharemarkets improved in July encouraged by a number of factors including a positive US June quarter reporting season where earnings exceeded expectations by almost 12%; strength in German manufacturing courtesy of a much lower Euro; and the release of the EZ bank stress tests which partially allayed market fears on the strength of the banking sector. In mid August positive sentiment gave way to renewed fears over the strength of the global recovery, particularly in the US. Yet as data releases in September failed to provide any conclusive evidence of a definitive slowdown, markets staged a minor relief rally. Critically, the September rally was on low trading volumes suggesting that market confidence remains low.
Global sharemarket valuations remain attractive in a historical context. As an example, the 1 year forward earnings multiple in the United States now stands at just over 12, much lower than the post tech boom average of 14.8. This would suggest that the market is either significantly undervalued or that investors view the earnings growth estimates for 2011 and 2012 as far too optimistic.
We remain of the view that economic growth is likely to slow in the United States and Europe in coming months. Such an outcome would jeopardise corporate earnings expectations that have been modelled on a continuing recovery. Admittedly, markets are already pricing in materially lower earnings expectations and so there is a real risk that markets could improve should data not deteriorate as expected. But it is impossible to ignore the formidable structural headwinds that continue to prevail as outlined in the International Economics section of this report. Accordingly, we continue to recommend an underweight exposure to international equities.
The Australian Real Estate Investment Trust (Listed Properties)
The Australian Real Estate Investment Trust (A-REIT) sector rose by 3.85% over the quarter ending 30 September 2010.
Conditions in the property trust sector continue to improve. Capital raisings and the disposal of non core assets have significantly improved balance sheets. Gearing levels have reduced to the point where financiers are allowing debt to be refinanced on longer durations once more (average sector debt maturity has improved from 4.2 to 5.1 years). Australian commercial property assets have outperformed their US and European counterparts. Despite rising interest rates, buoyant domestic conditions have been favourable. Retail trusts over FY'09/10 reported net operating income growth of 4% and occupancy rates approximating 99%. While earnings growth in the office sector has been more subdued, indicative of higher vacancy rates (Office vacancy rates: Sydney CBD 7.9%, Melbourne CBD 6.3%, Brisbane CBD 10.6%, Perth CBD 8.6%), property values have stabilised. Valuations in the industrial sector have also begun to stabilise in line with improved occupancy rates (almost 97% among listed trusts). In contrast, excess capacity in the United States (occupancy rates in US office, retail and industrial approximate 82%, 93% and 87% respectively) and Europe means that valuations remain under pressure.
Based on 2011 consensus earnings:
- The sector is trading on an earnings yield of just over 7%p.a.
- The distribution yield is just below 6%p.a.
- The discount to net asset values is around 6%.
On balance, valuation metrics are no longer compelling as against other asset classes. Equally, the sector is far from overvalued. Typically rising interest rates reduce valuations but this may be somewhat tempered by the improving demand fundamentals (high occupancy rates may translate into higher rental returns). As a result we maintain a neutral view on the sector in the coming quarter and so advocate a benchmark weighting. The uncertain global economic outlook remains the key downside risk to forecasts.
Fixed interest returned 1.28% over the quarter ending 30 September while cash returned 1.20%.
After 6 interest rate increases between October 2009 and May 2010, the RBA has left the official cash rate (4.50%) on hold since then.
The latest RBA minutes released on 7 September demonstrate that a tightening bias is very much in place:
"Members observed that previous investment booms and increases in the terms of trade had posed significant challenges for economic policy, and that high levels of resource utilisation were likely to put pressure on inflation.
The central scenario remained for the Australian economy to grow at trend pace, or a bit above, over the next few years...Members considered that if the central scenario came to pass it was likely that higher interest rates would be required, at some point, to ensure that inflation remained consistent with the medium-term target."
Despite the robust outlook, the Board left rates on hold in September due to ongoing concerns about the state of the global economy.
With unemployment near record lows, and the resources boom showing no signs of abating, the RBA stand ready to raise rates further should global growth fears ease. There is no question that the structural issues facing debtor nations are significant and so the risks of further dislocation to financial markets cannot be ruled out. Nevertheless, it is equally possible that global growth could continue to muddle along for some time yet and even improve further off a low base. Should the latter scenario eventuate then the RBA's patience may inevitably run out and further rate rises will eventuate. Given the conflicting possibilities, we have decided to err on the side of conservatism and so, over the coming quarter, recommend a moderate overweight position in cash and a neutral position in fixed interest relative to your asset allocation benchmarks.
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