2012 a good year for the share market

The ASX200 began the year at 4057 and finished at 4649. This should not have been a complete surprise. A year ago, I made the point that the Australian share market was fundamentally cheap, which is to say that the price/earnings (P/E) ratio was significantly less than its long-term average. This doesn’t guarantee that the market will rise---the same statement was true at the start of 2011 and the market proceeded to have a poor year—but it certainly paves the way for a positive performance. There are in fact two principal drivers of a rising market either it is driven by an improving earnings performance or it is “re-rated”, which is to say that the P/E ratio rises. In 2012, the latter force prevailed, while earnings forecasts were reduced over the course of the year.

The gains in 2012 were foreseen by many analysts. According to the Financial Review the average forecast of a panel of eight strategists made at the start of 2012 was that the ASX200 index would rise by 12.8%, to 4576. Even BT’s chief economist did reasonably well, foreseeing a rise to 4700. Given that the market actually pushed through 4700 on the first trading day of 2013, my forecast was, in a sense, out by less than a day.

2013 begins with a bigger challenge than 2012 did. Since the market is no longer massively cheap, gains this year are more likely to be driven by (need) earnings growth. And given the uncertainty about economic growth this year, mainly because of the impending end of the boom in capital spending in mining, there is a wide disparity of views about earnings growth this year, and hence a wide range of forecasts for the ASX200 index.

Again according to the Financial Review, the range of forecasts from a panel of strategists for end-2013 is from 4000 to 5100, with an average forecast of just 4557—lower than the current level of the market. If the average forecaster turns out to be correct, the market will be down in three years out of four. It’s a very long time since that happened! Equity investors would make a positive return for the year only because of dividends.

I should say that my forecast is equal to the highest of the analysts polled, but given the gloom of the panel on average, it is well to ask: where are the uncertainties?

The biggest relates to what happens when the mining capex boom ends. My (relative) optimism reflects a belief that the transition in growth away from mining capex will occur without over-much disruption. The RBA has prepared the ground for growth elsewhere by cutting rates as much as it has (the cash rate was lowered four times by a total of 1.25 percentage points in 2012). This is likely to lead to some response in consumer spending and in construction. Some of the growth in mining capex will also be replaced by mining exports, made possible because of the increased capacity of the industry.

There are, in addition, the ever-present overseas risks. The most prominent of these in recent weeks has been the “fiscal cliff” in the United States. As was always likely, political wrangling as to how to resolve this continued past the “deadline” of 1 January. On 2 January, agreement was reached on a (smaller) tax increase to replace the expiring Bush tax cuts and other measures. There is still work to be done on the spending side, but this will be done by the new Congress, which takes office on 3 January, and will probably not be finalised for two months or so.

And then there are Europe and China. The former will hang like a dead weight around the neck of the global economy, but is very unlikely to end in catastrophe. China, on the other hand, is just as likely to surprise on the upside as on the downside. As one barometer of the influence of China on Australia, the price of a tonne of iron ore, having fallen from $170 to less than $90, has recovered to close to $130.

Back to Australia

A year ago, I wrote scathingly of the view being pushed at the time, by one weekend tabloid in particular, that the Australian labour market was on the verge of crisis. At the time, the unemployment rate was 5.3%. It is now 5.2%. That said, some rise is likely from here, but unemployment should remain comfortably below 6%.

One thing that would help the Australian economy greatly would be a lower value of the Australian dollar. Last year, I made the point that the $A finished the year almost exactly where it started. This year, it began at 102.5 US cents, and finished only slightly higher, at 103.7 cents. Over the course of the year, however, it rose as high as 108.1 cents and sank as low as 96.5 cents. I have been spectacularly wrong in forecasting the currency in the past, so my credibility is not great. But I cannot envisage a world in which the mining capex boom ends and the $A remains super-strong. The currency should lose at least 10 cents over 2013.

In December, the Government announced that it was unlikely to meet its long-term commitment to achieve a Federal budget surplus in the current financial year. This should have surprised no-one indeed I made the point when the Budget was brought down in May 2012 that the commitment was very unlikely to be met. The Government was immediately assailed for “breaking its promise”. Its economic credibility, we were told, was in tatters. This is nonsense. To have slavishly done whatever would have been necessary to achieve the massive single-year turnaround required to deliver the surplus would have done the economy far more harm than good. It remains true, of course, that the Budget needs to be pointed towards surplus as a medium-term objective.

Chris Caton
Chief Economist