The long and winding road - Australian sharemarket
20 June 2011
Despite a stronger economy, Australian shares have underperformed other international markets over the last two years. Matt Sherwood, Perpetual’s Head of Investment Market Research examines what will need to happen to move the market out of its current trading range.
Australian shares – a long and winding road?
Since August 2009, Australian shares have underperformed our international peers by a wide margin and investors are wondering whether this is part of a long term trend. In this near-two year period, the Korean market (+30% in price terms), Germany (+29%), US (+25%) and UK (+19%) have all significantly outperformed the Australian market (+1%).
Despite a small relative decline during the global financial crisis (GFC) and a solid Australian economy, our sharemarket remains 33% below its November 2007 peak. In contrast, other markets are much closer to their pre-GFC peaks including Germany, the UK, US and some Asian markets (see Chart 1).
Chart 1: The Australian sharemarket is underperforming
Sharemarket performance: decline during the GFC and % from the peak
What catalysts have sparked underperformance?
Lower economic growth has not been a factor underpinning the Australian sharemarket’s relative underperformance. In fact, since the end of 2008, the Australian economy has grown 4.1% in cumulative terms which is more than other developed countries such as the US (3.4%) and Germany (3.3%). As Australia didn’t undergo a recession during the GFC, we are clearly in a more advanced stage of the economic cycle than other developed nations. However, there are four primary reasons for Australia’s sharemarket underperformance:
- Rising interest rates – since August 2009, the Reserve Bank of Australia has increased official interest rates seven times. In comparison, the Bank of Japan has eased rates once, the US Federal Reserve and Bank of England have not moved at all and the European Central Bank has hiked once. Rising rates have slowed the economy down, negatively impacted market valuations and reduced credit growth to below the levels seen during previous recessions.
- Appreciating exchange rate – The Australian dollar has increased 70% relative to the US Dollar since its GFC trough, which is more than double the rise of equivalent currencies. This has reduced the Australian dollar value of offshore earnings for Australian companies
- Our market composition – Very low credit growth has meant that Australia’s higher exposure to financial services firms (than our global peers) has negatively impacted relative performance.
- Earnings downgrades – With more policy headwinds and an unfavourable market composition, it is not surprising that the Australian sharemarket has been experiencing sustained earnings downgrades for the past 12 months. Single-digit earnings growth appears to be the norm for the domestic market, with more and more stocks seeing negative earnings-per-share growth.
The side trending market
This combination of factors has seen the Australian sharemarket trend sideways for nearly two years, even though economic activity has continued to rise (apart from the temporary impact of natural disasters). Side trends are typical after bear markets as the market needs time for earnings to catch up with valuations. However with no domestic economic recession, an appreciating Australian dollar and rising earnings per share, there may be some external influences at play.
External pressures have increased
More recently, investors have been concerned that the global economic recovery has hit a wall. Recent economic data has indicated that the US is experiencing weakness, China is slowing down, Europe is looking woeful and Japan is set to enter a recession. This has sent global markets into a small tail spin with the MSCI World Index down 4% in local currency terms, but the S&P/ASX 300 Index has declined by a much larger 9%. These concerns about economic growth are likely to remain for several months and may continue to weigh on market sentiment for a while.
What are the street signs truly telling us?
Despite the market volatility, most of these concerns reflect the impact of short term factors, rather than long-term structural issues. There has been a very cold and wet northern hemisphere winter, flow-on effects from the Japanese earthquake and inclement weather in the southern United States. All of these factors have combined to give the impression that the global economy is heading south. However, apart from Europe, it is hard to envisage these factors being sustained throughout 2011 and into 2012.
A two-stage end to the side trend
Despite the temporarily soft global economic climate, the Australian sharemarket may break out of its two-year side trend in the second half of 2011. This could occur over two stages:
Stage 1 – Global economic stabilisation
In stage 1, the global outlook will need to stabilise, as economic growth appears to be the key for the remainder of 2011. Importantly, it appears likely that global economic prospects will improve. For example, China is likely to only experience a moderate growth slowdown in the next few months and US growth should eventually pick up when Japan recovers.
Confirmation of all of these factors may enable the Australian sharemarket to stabilise and rise towards the top of its two-year trading band in the second half of 2011, as global risks diminish.
Stage 2 – Breaking through the top of the side-trend
While employment growth is essential for any continuing economic recovery, earnings growth is also essential for any sharemarket rise to be sustained.
With Australian sharemarket valuations appearing attractive at 11.3 times 2011-2012 earnings (which is a 22-year non-recession low), the earnings outlook for Australian listed companies will need to improve to move the sharemarket higher. This will probably require Australian interest rates and currency to stabilise (which could be occuring as we speak) and increased confidence in the global economic recovery and a stronger US Dollar.
Meanwhile, the expected domestic mining investment boom in 2012 is also likely to support Australian economic growth, which would be expected to have a positive impact on corporate dividends. This is because there is a very strong relationship between nominal gross domestic product (GDP) growth and dividend growth over multiple business cycles (see Chart 2).
Chart 2: Our last mining boom produced record dividend growth
Australian listed company dividends and nominal economic growth (%pa)
During our last mining boom in late 1960s, the Australian sharemarket recorded its highest period of dividend income growth, which is one of the key drivers of share price trends. If investors believe the Australian economy’s outlook is good in the next decade on the back of our second mining boom, then Australian shares might break out of their trading range before too long. However, this appears to be a little way off at present.
Implications for investors
Sharemarket investors may think that they are on a long and winding road, however, history and the economic dynamics suggest that there may not be long to go on that journey. The current global economic slowdown appears to be a series of temporary impacts, rather than a structural downturn. Global growth is likely to pick up in the second half of 2011 and this should provide some uplift for advanced economy sharemarkets. Although the Australian market is being held back by several factors, these should diminish in the next six months.
In this environment, shares that provide a consistent cash flow, growth in dividend income and valuations are the ones to watch and should outperform in a more difficult trading environment.
This article has been prepared by Perpetual Investment Management Limited (PIML), ABN 18 000 866 535, AFSL 234426. It is general information only and is not intended to provide advice to particular investors, or take into account an individual's objectives, financial situation or needs. You should consider, with a financial adviser, whether the information is suitable for your circumstances. The views expressed in the article are the opinions of the author at the time of writing and do not constitute a recommendation to act. Any information referenced in the article is believed to be accurate at the time of compilation and is provided by Perpetual in good faith. To the extent permitted by law, no liability is accepted for any loss or damage as a result of any reliance on this information.
This information has been prepared by Perpetual Investment Management Limited (PIML) ABN 18 000 866 535, AFSL 234426. It is general information only and is not intended to provide you with financial advice or take into account your objectives, financial situation or needs. You should consider, with a financial adviser, whether the information is suitable for your circumstances. To the extent permitted by law, no liability is accepted for any loss or damage as a result of any reliance on this information. No company in the Perpetual Group (Perpetual Limited ABN 86 000 431 827 and its subsidiaries) guarantees the performance of the Fund or the return of an investor’s capital. An investment in the Fund is not a bank deposit, nor is it a liability of the Perpetual Group. It is subject to investment risk, including loss of some or all of an investor’s principal investment and lower than expected returns.