The Australian stock market is marching toward the 2013 high of 14 May when the All Ordinaries was at 5,202.5 and the S&P/ASX200 at 5,221.0. As the second week of the 2012/13 reporting season closes there have been no significant negative surprises. (In Australia, the fiscal year starts on July 1 and ends on June 30.) August and September are traditionally weaker months for the stock market. What is behind the newfound confidence, given the rather dire economic outlook suggested by several bodies including the Reserve Bank of Australia and the International Monetary Fund and a raft of economists and commentators?
Global economy looking better
Perhaps most of the negatives were already accounted for in stock prices, and any semblance of positive news attracts buyers. From a global economic perspective one could argue the pendulum is gradually moving into positive territory.
There seems to be mounting evidence in the U.S. for the Federal Reserve's Open Market Committee (FOMC) to start reducing the rate of monthly asset purchases from US$85 billion. Atlanta Fed President Dennis Lockhart again reiterated economic data will determine when the "taper" starts. And while there may not be enough evidence just yet for a move in September, investors should note the initial FOMC tapering decision "ought to be thought of as a cautious first step." Perhaps the first cut could be a tentative US$5 billion. But there is little doubt the world's largest economy is improving. Bank lending is expanding, which will help the velocity of money vital to reviving economic activity.
The Eurozone remains hamstrung but there are signs the economic contraction has run its course. In the second quarter of 2013 the zone achieved GDP growth of 0.3% against negative 0.3% in Q1. Germany (+0.7%) and France (+0.5%) were lifters while smaller-than-expected contractions were recorded in Italy and Spain. While a meaningful rebound is not anticipated, a modest and gradual improvement is possible. The situation in the United Kingdom is certainly lifting, with industrial production and retail sales recovering and house prices showing modest improvement year on year. While this is far from robust, it is possible the worst is over in Europe.
Japan, the world's third largest economy, is responding to a dose of Abenomics designed to rid the economy of deflation. Early signs are positive, though not without risk. Industrial production, retail sales, GDP and inflation are all pointed in the right direction, but it is still early days. As Australia's second largest trading partner behind China, any improvement in Japan is positive for Australia.
And lastly China: a hard or soft landing for the second largest and most closely watched economy? There are plenty on the bandwagon predicting GDP growth to slow from near 8% per annum over the past decade to just 5% as the economy transitions from one driven by investment and infrastructure to a more westernised consumer-based economy. I stand firmly in the soft landing bucket. The new regime is prepared to defend GDP growth at 7% with recent data showing a slight slowing to near 7.5%. This is an economy that has doubled in size over the past eight years and 7% growth is still very meaningful and demands significant volumes of Australian resources to satisfy a still very large infrastructure build.
So overall the global economy is probably in its best position for some years. Numbers one and three improving, number two slowing moderately but not sliding to a hard landing, and the Eurozone/UK bottoming. Rising long-term bond yields in the U.S. and Germany are supportive of the improving trend as the inflation genie remains contained at present. An improving trend would support corporate earnings and dividend growth which the market sees with P/E expansion.
Australia has issues, but…
Domestically, much is said of the end of the resources investment boom. Yes, it has peaked, but there is a "fat tail". The Australian Construction Industry Forum (ACIF) suggests the level of demand for building and construction will remain at elevated levels for years to come. Recently released Forecasts and Construction Market Reports show that while the rate of work peaked at record levels, "it will take 10 years for engineering construction demand to fall to a level that will still be double that of the work available 10 years ago." Along with mining demand, large government infrastructure projects are driving growth in this area. There will be positive spin-off effects on residential building activity, and record low interest rates will play a supportive role. New South Wales, the country's most populous state is showing signs of a revival in housing construction after a decade in the doldrums. Increased land releases and hopefully less red tape will aid activity in an undersupplied market.
House prices are increasing with the traditional leader, the Sydney market, showing the way. Auction clearances are buoyant and any further cuts to official interest rates will only heighten interest. Investors are actively seeking alternative investments as real after-tax cash returns approach zero. A housing bubble must be avoided at all costs.
Now to the 2012/13 reporting season. The banks represent almost a 30% weighting in the S&P/ASX 200. The largest, the Commonwealth Bank, is the only one of the four majors with a June 30 balance date. It was imperative it delivered a solid result in a low credit growth environment and a positive outlook for 2014. It delivered on all counts, lifting cash earnings by 10% to a better than consensus AUD7.8 billion with a AUD2.00 per share fully franked dividend taking the annual dividend to AUD3.64 per share. The banks are one of the sustainable dividend bookends. The other includes Telstra, which also lived up to all expectations with solid earnings, free cash flow and sustainable dividend and a positive outlook.
In challenging conditions, JB Hi Fi, Domino's, REA Group and carsales.com delivered. Even Bradken and Downer, plagued by severe cutbacks in mining company expenditure, reported lower but still solid results modestly above consensus. CSL and Cochlear opened the batting for the international health care companies positively. So in the early days of the reporting season results are generally favourable in a market with low expectations.
Resources stocks have also been strong participants in the market's push toward 2013 highs. Heavyweights BHP Billiton BHP and Rio Tinto RIO along with Woodside are the big lifters with the spot iron ore price rising against the opinion of most in the market. This helps Rio with 80% of earnings before interest and taxes for the first half of 2013 coming from iron ore operations. Reasonable copper prices and a strong oil price also helps BHP Billiton. We still see these stocks as relatively attractive.
There is some comfort in fair value estimates given critical commodity spot prices of iron ore, copper, oil and liquefied natural gas are well above long-term forecasts. So in summary the market appears relatively comfortable around current levels. Our Morningstar market-cap-weighted price-to-fair-value sits at 1.02. A reading of 1.0 indicates fair value.
The global economic pendulum is gradually moving into positive territory. China is not imploding. Stock markets have improved and house prices in the U.S. are recovering with household wealth reflecting higher asset prices. The U.S. consumer is resilient and bank lending is increasing, which should drive economic activity.
Australian company profits are so far meeting or exceeding expectations with dividends reflecting earnings growth. Cost containment helps where revenue growth is subdued, resulting in revenue growth exceeding cost growth. Efficiency measures improve and margins expand. With the possibility of another cut in the official cash rate later in the year to 2.25%, the one-year bank term deposit rate could fall to below 3.20%. Over 85% of bank term deposits are one year or less. The Australian 10-year bond yield is now 3.86%.
