The worst of the downgrade cycle is over

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It is said that markets are forward looking, and the performance of the Australian share market in recent months is a case in point.  It’s now clear, in hindsight, that by mid-2012, the market had already priced in weak economic growth and substantial earnings weakness, and was starting to look forward to an expected bottoming out in the earning cycle.

The latest earnings reporting season seems to have confirmed what the market has been telling us all along: this season probably marks the worst in the earnings downgrade cycle.

Better than anticipated

Indeed, with expectations for earnings growth for this financial year having already been beaten down late last year, earnings reports to date have thankfully not been a lot worse than expected.  Almost half the companies reporting beat market expectations – the best result in three years according to records kept by AMP Capital Investors.

Note the last significant bottom in the local market was back in early June 2012, and since then share prices have lifted by almost 30%.

Much of this rally has been met with disbelief by investors, particularly as the local earnings outlook still remains quite muted. Indeed, our miners were facing falling world prices for coal and iron ore, while bankers were fretting over persistent weak credit growth despite lower interest rates.

Earnings expectations were progressively revised down over the second half of last year, such that earnings for this financial year are now expected to be broadly flat – rather than rise by the 12% expected back at the market bottom in mid-2012.

But back in June 2012, the market’s price to forward earnings ratio was only just over 10, or well below its average of around 13.5 for much of the past decade. Relative to exceptionally low interest rates, the equity market was especially cheap.

What’s more, reflecting weak domestic demand and falling commodity prices, forward earnings have been weak for a while – and well below their trend over the past few decades. So the market was cheap at a time when earnings were also cyclically weak.

What’s next?

So far so good, but where to from here? Note the biggest driver of the downgrade to earnings last year was weakness in commodity prices – which slashed expected earnings growth among our major mining stocks. A weaker than anticipated pick up in consumer spending and borrowing also dampened financial sector and consumer discretionary earnings.

According to Thomson Reuters estimates, analysts expect earnings to grow by 12% next financial year – driven by a sharp 30% rebound in mining sector earnings and, to a lesser extent, a 10% lift in earnings in the consumer discretionary sector. Financial sector earnings – one third of the market – are expected to hold steady at around 6%.

Meanwhile, at 14.3 times forward earnings, the market is no longer as cheap as it once was – but not as expensive at it has often become in the past. The PE ratio is a bit above average, which is reasonable if analysts’ bullish earnings expectations are closer to the mark in the coming financial year than they were this year. Note also that local and international interest rates remains exceptionally low, and with inflation a non-issue for now, the Reserve Bank has a strong bias to ease interest rates even further should the pick-up in non-mining economic growth falter. An anticipated lift in earnings, low interest rates and a supportive central bank also help justify some premium in share prices relative to current earnings.

Of course, we’ll need to see a lift in earnings soon to justify the market’s recent optimism. In this regard, the sharp rebound in iron ore prices on the back of firmer growth in the Chinese economy is a positive sign. The tentative upturn in local housing demand is also reassuring, though households still remain cautious in their use of debt. In somewhat mixed news for the economy, many companies this reporting season have also indicated their intent to focus on costs and boost productivity – which is good news for profits, but could add to household caution if the result is also a transitional lift in unemployment.

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.

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