Earnings disappointments but resilient economic growth
As yet another disappointing ASX earnings season winds down, the post mortems begin with the now-familiar messages. Once again, profit growth has proved elusive but while sales revenue has been disappointing, cost cutting has partially offset the lack of top line growth. In addition, dividends have been maintained, given growth opportunities remain scarce. Sound familiar? It should. It’s been the same message for the last 4 -5 years.
In line with a succession of lacklustre reporting seasons, the ASX 200 has generated just 6-7% growth (ex-dividends) since 2010 and still remains 20% below the pre-GFC peak. As the charts below reveal, both the resource sector and private non-financial profits as a percentage of GDP, peaked back in 2009. Consequently, over-optimistic earnings forecasts have been downgraded over the course of every year since 2011/12.
In contrast to the poor performance of the equity market, the Australian economy continues to outperform the global peer group. This conundrum poses a dilemma as investors continue to await an earnings recovery.
The lucky country-resource rich
Australia is universally regarded as the lucky country. That tag is almost certainly the result of an abundance of natural resources. This endowment has supported the old maxim, “Australia has always ridden on the sheep’s back.” More recently, commodity exports, particularly iron-ore coal and LNG, have provided a cushion from the ravages of the GFC and the subsequent global recession.
As a result, domestic growth has remained resilient and the economy recession-free for 23 years. Currently, GDP growth is around trend at 3.1% pa. This is a truly remarkable achievement compared to the moribund growth of the Western world. Sadly, the equity market has failed to capture our economic resilience and good fortune. Why? Maybe the series of RBA charts below will prove instructive?
Strong exports-weak commodity prices
The conventional wisdom appears to suggest that the uptick in GDP growth is proof of a successful economic transition away from the mining boom. On the surface, this analogy appears true. But despite the surge in exports, commodity prices have fallen dramatically. A transitioning Chinese economy has acted to weaken resource demand which, in turn, has undermined the terms of trade.
Consumption spending, retail sales-the weak link
A cascading effect from the fall in the terms of trade has resulted in a negative impact on both household disposable income and consumption spending. Considering an approximately 60% contribution to GDP, the continuing weakness in consumption has negative implications for economic growth. Similarly, retail sales, which provide a large contribution to consumption spending, have also been negatively affected.
In the background, the lingering effects of the GFC, and the end of the mining boom, continue to support a higher savings ratio. Of course, this trend has exacerbated the fall in disposable income which, in turn, has acted to constrain consumer spending.
The housing sector – the new black
On the positive side, housing has taken the mantle from the mining sector and continues with most of the heavy lifting for the economy. With the lowest cash rate on record, and driven by a strong building approval and home lending cycle, housing is providing the current resilience in domestic economic growth.
At the same time however, the data indicates that the current residential cycle has peaked, or is in a topping process. Without the strength of a strong housing sector, the prospect of economic growth remaining near trend, is at risk without a recovery in consumption spending and retail sales growth. At the moment, such a recovery is very uncertain.
Economic growth – is it sustainable?
Set against a backdrop of slow consumption spending and the possibility of a cyclical housing peak, both private and public debt levels remain elevated. Indeed, with the fall in the cash rate, the ratio of household debt to disposable income has surged to record highs. This will almost certainly act to constrain consumption spending. Although low rates have reduced interest paid, households remain extremely vulnerable to a rise in interest rates.
In addition, foreign debt levels are skyrocketing driven by a sharp deterioration in the budget finances. The prospect of a political policy gridlock can only contribute to the increase in gross public debt levels. More importantly, the rapid escalation of household and government debt, would appear to indicate that Australia has already borrowed from future economic growth. The signs are worrying.
In the meantime, dividends continue to rise as corporates seek to return capital to shareholders. An increase in dividend payout ratios (ASX 200 75% average) has resulted in a misallocation of resources away from business investment and capital expenditure. Once again, this trend can only act to further weaken both economic growth and corporate earnings.
A light on the horizon or an oncoming train?
Current forecasts assume FY 17 earnings growth of 8-9% for the ASX 200. As such, the forecast assumes the biggest earnings recovery in the last 4-5 years. This would appear unlikely given a mediocre FY16 reporting season and a lack of company guidance. On the other hand however, with current GDP growth just below trend at 3.1%, this optimism could have some justification.
Investors are between a rock and a hard place. With an ASX 200 earnings yield of nearly 6% and a Commonwealth 10 year bond yield of 2.10%, equities remain the clear asset class of choice. But the outlook for economic growth and corporate earnings is far from certain. Particularly looking at the recent past and current economic trends.
Meanwhile, with the ASX 200 forward PE trading at 16.7x, or 15% above the long-term average, an earnings recovery is already priced in. Following another lacklustre earnings season, the outlook for Australian equities remains opaque, and the risks of further earnings disappointments is high.
On that basis, I continue to believe the right course of action is to be a “stock-picker”. The ASX200 itself may give you nothing much, as has been the case for five years. Yes, you can pick up dividends and franking credits in large cap Australia, but capital growth is much harder to find. In fact, capital losses are much easier to find in large cap Australia over the last five years.
What I am trying to reinforce today is I see more of the same. Large cap Australian equities providing tax effective dividend income and nothing much else. If you want capital growth, you need global exposure and the right individual growth names in Australia, the vast bulk of which are outside our top 20 names and I’ve written about in these notes this year (TWE, ALL, SGR, LNK etc.)
At Aitken Investment Management (AIM) we have around 30% of our investments in Australia/NZ, 30% in Asia (ex-Japan) and the rest in the USA/UK. It gives us a mix of income and growth that is driving the fund to solidly outperform all global and local equity benchmarks. The fund also has markedly lower volatility than the equity benchmarks. We see no reason to change that asset allocation mix after the somewhat lacklustre ASX large cap reporting season.
Important: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. Consider the appropriateness of the information in regards to your circumstances.
