While many continue to view the Australian economy as being dominated by resources and commodity prices, in reality, this is not the case. Indeed, the Australian economy is transitioning, with more important drivers of growth coming to the fore, giving us good reason for optimism in 2016.
Important growth drivers
It is not difficult to understand why resource areas remain the focus of investor attention, given the swings in a cycle, from peak to trough, are often significant, leading to dramatic movements in commodity prices. However, in reality, only around 5% of the Australian workforce is linked to mining-related parts of the market. This is in contrast to the 40% working within retail, construction and manufacturing sectors. Clearly, from an employment perspective, it is these areas that matter most to the Australian economy, given the much larger concentration of workers.
It is also true that exports make up only around 20% of the Australian economy – a low level compared to many other countries – and of this 20%, roughly 30% goes to China. Interestingly, one of the growing parts of the Australian export sector is services, specifically education and tourism.
These sectors combined now constitute a larger percentage of exports than iron ore. A major change in recent years has been the significant increase in tourism, driven by the fall in the currency. Having peaked at parity in mid-2011, causing inbound passenger numbers to dwindle, the Australian dollar is now trading at around 72 cents against the US dollar. This is very important from an employment perspective because, unlike the mining sector, the tourism industry is very labour intensive. This is one of the reasons why the job market has surprised, with Australian unemployment currently around 5.9% – better than many anticipated.
A rebalancing economy
Indeed, what we are seeing is a rebalancing of the Australian economy – shifting away from the largely export-focused, resource-dependent growth of five years ago, toward growth that is driven more by the domestic and service-related parts of the economy. Annual GDP growth in Australia improved in Q3 2015, expanding 2.5% year-on-year, up from 2% in Q2.
This is in line with our expectations of around 2.5% growth in 2016. Some of this will be driven by the resources sector, as a number of large projects move into the production phase, boosting output volumes. However, we anticipate further positive impact from tourism while the falling Australian dollar should also help stimulate the domestic manufacturing and services base.
Market valuations appear reasonable
Australian equity valuations look reasonable currently, trading at roughly 15x earnings, in line with the 20-year average. The equity market also looks appealing relative to other asset classes, with fixed income, property and infrastructure, all trading at comparatively expensive levels. While we expect corporate earnings to be broadly flat overall in 2016, certain sectors can deliver improved earnings in our view. Unsurprisingly, the main drag on forecast earnings is the resources sector, given the ongoing impact of weak commodity prices. Elsewhere, however, we envisage increased earnings from financials and general industrials, while we expect the best earnings growth to come from long-term growth areas like healthcare. Two stocks that we have a positive view on currently include:
CSL
CSL (CSL) has an attractive and durable growth profile owing to its strong portfolio of human derived plasma products. Over the next 12-months the company is expected to launch two new recombinant haemophilia products, which should accelerate earnings growth even further. CSL is one of the largest plasma fractionators globally, operating in a concentrated industry, which is conducive to attractive returns on capital. In addition, the company has a high yield per litre of plasma due to its broad array of specialty products, which are very high margin. The recent acquisition of Novartis’ flu business also expands the company’s presence in this market. This business is expected to make a contribution to earnings growth in fiscal 2017.
Source: Yahoo!7Finance 21 January 2016
Brambles
Brambles (BXB) is the dominant provider of outsourced pallet pooling solutions globally. This gives BXB significant economies of scale and strong protection in the form of barriers to entry against competition. We like the consistency and durability of BXB’s growth and the strong returns on capital generated by the business model. Growth is driven by a combination of higher activity from existing customers and market share gains from the conversion of customers to outsourced pallet pooling solutions. This drives revenue growth in the mid-to-high single digits and with operational leverage we expect this to translate into double-digit earnings growth. A stronger US economy is expected to see some acceleration in growth, while margins and returns should benefit from improvements made to the durability of the pallet pool. BXB is also the largest provider of returnable produce containers globally – a less penetrated product with many years of strong growth from market share gains expected.
Source: Yahoo!7Finance 21 January 2016
The outlook is not without risks
Valuations in the yield-related parts of the equity market appear stretched in our view. The 20-30% annual returns from infrastructure and property in recent years do not look sustainable. While the business models are reasonable, infrastructure companies, for example, are gearing up significantly in a very low rate environment, expecting this to remain the case.
For some, debt levels are higher today than prior to the financial crisis, yet investors continue to ignore this fact in their quest for yield. If, for example, the US Federal Reserve decides to raise interest rates further or faster than anticipated, then this will prove challenging for global markets generally, but especially for sectors regarded as bond proxies, like infrastructure. Investors should be clear about the fact that we are in a government bond yield bubble created by central banks and exactly how this is unwound over the coming years will be very important for asset returns everywhere.
With the Australian and the global economy looking reasonably healthy, a supportive domestic monetary environment, as well as the lack of attractive asset class alternatives, we believe that the Australian equity market offers the potential for improved returns in 2016.
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