The sharemarket rally isn’t over

The market has dropped … but it’s only taking a breather.

Summary: The market rallied hard from mid last year, breaching 5,200 only a few weeks ago. Now it’s down around 500 points since its peak, and investment fear is evident. But positive economic signs on the global front, particularly from the US, are good news for global equities, and the Australian market is poised for renewed growth.
Key take-out: With interest rates likely to remain at record lows for this year, the yield theme that has dominated equity markets still has some way to run.
Key beneficiaries: General investors: Category: Growth.

The rally that began in 2012 has merely taken a breather. And it has occurred at crucial point in history as the earnings handbrake that has constrained the non-resources sector has begun to be loosened.

For all the talk of transition and rotation in recent times, the past few weeks has been dominated by just one factor. Fear.

Has the rally run its course? Is Australia on the precipice of a recession? Is it time to switch back to cash?

The answer to each of these questions is a resounding, no.

The Australian stockmarket has been oversold as foreign investors have attempted to limit foreign exchange losses. Domestic institutions have followed suit, accelerating the declines, just as a brighter outlook for corporate earnings has emerged.  If ever there was a buying opportunity!

For all our smug superiority, our notion of higher intelligence and capacity for individual thought, it doesn’t take too much for human beings to revert to a pack mentality.

For the best part of a year, there have been mounting concerns that corporate earnings growth was anaemic and incapable of supporting the rally that began in July last year. Valuations were too stretched, multiples too high.

Given an artificially inflated currency was acting like an anchor on the non-resources sector, along with interest rates well above those of other developed nations, they were legitimate concerns.

But consider the situation now. The two factors that have weighed down our equities market for the past four years are being not so much chipped away, as hauled off in one of Kerry Stokes’s spare Caterpillar trucks.

The Australian dollar is in the early phase of settling into a long-term position below parity with the greenback, while the Reserve Bank maintains an easing bias with the possibility of at least one more rate cut before September. And that’s on top of the 200 basis points in cuts in the past 20 months.

This seismic shift has been accompanied by a dramatic correction on the domestic bourse that has seen almost 10% wiped from the value of Australian equities in just three weeks.

Consider those trends just for a second. Prices suddenly have plummeted just as every analyst in town is desperately trying to calculate the boost to earnings from a weaker currency and lower interest rates. Prices down, earnings up. There seems to suddenly be a great deal more elastic in the valuations.

And with interest rates likely to remain at record lows until well into 2014, the demand for yield remains firmly in place, underpinning the foundation for the rally that began last year.

Despite the ructions of the past month, caused largely by US Federal Reserve chairman Ben Bernanke’s oblique comments on the possible winding down of America’s radical money printing extravaganza, there are positives on the global front as well.

Bernanke finally can see signs of a recovery in the world’s biggest economy and a return to more normal policy settings. That’s no bad thing. An American recovery is desperately needed to restore the global economy.

You didn’t need to be a genius to figure out that with the American housing recovery in full swing and a gradual decline in US unemployment, the methamphetamines would need to be withdrawn. Still, it seemed to come as a shock to the professional traders, addicted as they’ve become to the medication rather than the prospect of a cure.

On Monday, Goldman Sachs added to the fear factor, predicting the Aussie dollar would slump to US85 cents within 12 months, with a 20% chance of a recession. Presumably that means there is an 80% chance there won’t be a recession. And if the Aussie does fall to that level, there will be a potpourri of investment opportunities.

We know monetary policy works because it always has in the past. It is the timing that is uncertain. But at some point, Australian consumers will rediscover confidence, as will business. For the short term, rising unemployment will dog the domestic economy as resources sector construction winds down.

But a rejuvenation of domestic service and manufacturing industries should pick up the slack in the medium term.

Bargain hunting

The sell-off in recent weeks has been broadly based but has been more pronounced on the yield plays, particularly the banks and REITs. Domestic cyclicals also have been hard hit, as has discretionary retail and mining services companies.

The best performers have been US-linked stocks and resource stocks which earn most of their income in US dollars.

It is worth remembering that the weaker Australian dollar will boost not only exporters or those repatriating foreign income but also domestic-based companies that compete against imports.

One of the biggest drags on earnings for such companies in the past few years has been the flood of cheap imports. Those that have survived the onslaught are now in a good position to benefit from the currency shift.

Steel, retail and construction materials are just some of the areas that will lift. On a broader sector perspective, however, resources should be among the biggest beneficiaries of a falling currency.


Deutsche Bank analysts estimate that at US95c, resource sector earnings should lift 12% in 2014, while a drop to US90c would boost the sector earnings by 22%.

Those with the greatest upside potential are companies with revenues in US dollars and costs in local currency. They, however, tend to be smaller operations with less diversification. Coal producer Whitehaven, for example, would be among the biggest beneficiaries of a currency drop, with a 200% earnings impact on a currency fall to US95c.

Among the bigger miners, BHP would receive a 10% boost to earnings from a sustained drop to US95c, while Rio Tinto would enjoy a 9% lift. Given its greater diversification and hence less exposure to a drop in iron ore demand from China, many analysts prefer BHP to Rio Tinto.

Energy is also considered attractive, with Santos’ earnings lifting 9% on a fall to US95c and Oil Search rising 7% in Australian dollar terms.


Within this sector, the numbers are skewed by the potential downturn in earnings by Qantas, given its huge US dollar cost base.

Incitec Pivot is likely to be a major beneficiary of a lower Australian dollar ,with a 15% lift in earnings in 2014. Others to watch are BlueScope Steel, with a projected 16% lift, CSR with a forecast 32% lift, Arrium with 14% and Simms with a 7% lift. These projections come from Deutsche analysts, and all are based on a drop to US95c.

Other studies in the past week point to renewed interest in domestic cyclicals, with names such as Seek, Harvey Norman, Seven West Media, Super Retail Group and JB Hi-Fi.


There is no real upside for the banks from a weaker Australian dollar. ANZ is the only operation with significant exposure to US dollar earnings through its Asian operations.

But the selling in bank stocks during the past few weeks, which has seen almost 13% wiped off their value, has removed most of the excess. The price earnings ratio of Australian banks now has reverted to its long term average of a little above 12.


The rally that began in 2012 has merely taken a breather. And it has occurred at crucial point in history as the earnings handbrake that has constrained the non-resources sector has begun to be loosened.

Poor sentiment continues to plague the economy, both at a consumer and corporate level, and this is likely to continue for the remainder of this calendar year.

Globally, however, there are positive signs that America is emerging from the shadow of the recession that has crippled its economy. This is good news for the global economy and global equities.

With interest rates likely to remain at record lows for this year, the yield theme that has dominated equity markets still has some way to run. But a broader recovery, particularly in Australia, is entirely possible.

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