Equities in the year ahead

Business Spectator asked leading fund managers and analysts how they see the equity market shaping up in 2014. What can investors expect after a year in which the local market produced total returns of 20 per cent?

The comments come from:

George Clapham, Managing Partner, Arnhem Investment Management

Shane Oliver, Head of Investment Strategy, AMP Capital

Simon Burge, Chief Investment Officer, ATI Asset Management

George Whitehouse, Portfolio Manager, Clime Asset Management

Mark Daniels, Investment Director, Aberdeen Asset Management

Q1: What are your expectations for the Australian equity market this year?

Clapham: Earnings growth is the linchpin to sustaining positive equity returns. Over the last two years, earnings growth has been elusive and stocks have benefited from considerable price/earnings expansion (circa 40 per cent). Nonetheless, we believe the re-pricing of stocks is not excessive given a) stocks were significantly oversold post the financial crisis; b) interest and inflation rates remain low; and c) global growth is picking up.

Oliver: My end-2014 target for the ASX200 is 5,800, which would translate to a total return (capital growth dividends) of around 12 per cent. In other words, I expect another solid year albeit a bit slower than 2013's 20 per cent total return. The market is likely to be underpinned by a slight pick-up in global and Australian economic growth, driving higher profits at a time when valuations are around fair but monetary conditions remain very easy. I do see more volatility this year. After the run-up of the last few years, global and Australian shares are no longer dirt cheap and so are now more dependent on profits delivering.

Burge: The “easy money” has been made from the Australian sharemarket in 2013. A reduction in global risk aversion has seen a substantial rally in global share markets, which has not been matched by corporate profits. We would expect single-digit capital gains this year. A sell-off in bond markets is also likely to continue into 2014. 

We continue to see dividend yields supporting a large part of the market, and favour large-cap stocks in terms of alpha generation. Stocks leveraged to a weak Australian dollar currency, improving capital market conditions, undergoing “cost-out” programs, with strong franchises and pricing power will continue to do well. 

Whitehouse: Our December 2014 All Ordinaries valuation is 5,550, with 5 per cent earnings growth. This implies a total sharemarket return of 7-9 per cent, plus franking from the equity market this year. We see forward equity returns much closer to the All Ordinaries accumulation 20-year average of 8.88 per cent. At times one can simply buy broad equity exposure and expect to do well, this occurs when equities in general are unpopular and as a result available cheaply. Today is not one of those times.

Daniels: While domestic sentiment and the stock market have improved over the short term, we think 2014 will be a tougher year for Australian equities than 2013 and we are not expecting another year of strong performance. One of our key concerns is that valuations have run well ahead of earnings growth and investors have to pay more for decent yields that come with less certainty of being paid. Our medium-term outlook is one of caution, as we anticipate domestic consumers and businesses to continue to adjust to incoming cost pressures.

Q2: What are your preferred sectors, and why? Any stocks in particular?

Clapham: We forecast earnings growth of 17 per cent for the ASX200 in FY2014 compared to minus three per cent in FY2013.  The sectors with the strongest expected earnings growth are financials (ex-banks) up 28 per cent (improving financial markets); resources up 23 per cent (lower costs and higher iron ore prices); energy up 22 per cent (expanding LNG production); and healthcare up 14 per cent (lower Australian dollar, growing demand).

We have a bias towards companies exposed to industries with sound structures and with high earnings sustainability. Companies we favour include Crown, ResMed, Fox, Computershare, Aurizon, Orica and Carsales.

Oliver: I see the best return opportunities as being in the cyclical sectors that have underperformed in recent years such as materials (including resources) and industrials. These should benefit from improving economic growth and come with the cheapest valuations. 

Burge: We feel that no particular sector is cheap at the moment as the market has had such a PE expansion, but our portfolio is overweight telecoms and healthcare.

Daniels: Over the year Rio Tinto and BHP Billiton announced new members to their senior leadership teams, and both new chief executives are doing the right thing by focusing on productivity and lowering per unit costs. We believe valuations are cheap in resources, and these companies are well positioned to capture the future long-term growth from China.

A weaker currency should benefit exporters and slow but steady improvements in the US and European economies should bode well for our holdings with offshore revenue streams, such as CSL Ltd.

Q3: What are your least preferred sectors?

Clapham: Sectors with the weakest earnings growth prospects are gold (down 28 per cent), telcos (up 3 per cent), property (up 4 per cent), consumer staples (4 per cent) and banks (6 per cent). We do see ongoing structural earnings risks in contracting services sectors, life insurance, old media and bricks and mortar retail and property.

Oliver: Financials are likely to be relativel underperformers after having had a strong run and as gradually rising bond yields act as a bit of a drag. Retailer/consumer discretionary stocks have probably also factored in the bulk of the acceleration in retail sales growth that will occur this year and so may also be relative underperformers.

Burge: Our portfolio is underweight: Consumer staples, energy, and industrials.

Daniels: We are happy to maintain our underweight to banks, in particular by not holding NAB. We find it difficult to believe that the domestic growth outlook warrants these valuations, especially compared to regional Asian banks which have so much more growth potential through their exposure to Asian markets.

Q4: Are there any particular issues for investors to consider in the upcoming H1 corporate reporting season in February?

Clapham: The earnings picture looks promising for many Australian companies, particularly when coupled with some positive earnings drivers such as a lower Australian dollar and improving global growth.

Oliver: The main things to watch are improving resources profits – particularly on the back of the relatively robust iron ore price, the lower Australian dollar and continuing cost controls – and outlook statements from non-resource companies regarding domestic demand conditions.

Whitehouse: Consensus has one-year forward earnings growth as a little over 10 per cent. We think this is quite optimistic given the economic headwinds we are likely to see this year and the recent wave of downgrades by local corporates recently. We think around 5 per cent is much more likely with relatively benign economic outcomes.

Burge:  The “black out period” ahead of reporting season in late January, early February represents a relatively quiet period for investors. High yielding investments will continue to be sought in the low interest rate environment but investors should be wary with long-duration assets in a rising long bond rate environment.

We continue to be positioned towards large-cap global and domestic cyclicals with the major banks still our preferred means of exposure to the higher yielding opportunities due to our confidence in their ability to meet or exceed their current earnings estimates as viewed by the market consensus.

We feel that reporting season needs to be better than expected if this market is to stay up at these levels. Outside the major banks, we feel that iron ore stocks (BHP, RIO, FMG) will all report good numbers as the spot iron ore price has remained well above the market consensus expectations.

Daniels: We think the mining service sector may struggle, due to a slowdown in capital projects either from deferment or cancellation. We will be watching to see whether the very early signs of a recovery in the housing sector translate into results, or whether it is too soon.