Aussie equities underperform global peers

Sharemarket Insights

• The Australian sharemarket has significantly underperformed other major overseas markets this financial year. Some of the factors that have led to this under-performance include higher domestic interest rates, the strength of the Australian dollar and the lack of near term growth.
• CommSec still expects the Australian share market to rise over the rest of 2011, however we have cut the end year forecast from 5,400 points to 5,200 points.

Aussie shares out of favour?

• Many investors would be disappointed at the performance of the domestic share market this year in comparison with overseas indices, especially given that last year the domestic economy showed far more promise and seemed to be well ahead of its peers. Since the start of 2011 the ASX200 has fallen by 2.1 per cent while the broader All Ords index has lost 2.3 per cent. In contrast the US Dow Jones has gained 3.8 per cent, while the US S&P500 is up almost 3.0 per cent.
• No doubt the heightened sense of risk aversion in the last couple of weeks has resulted in the considerable under-performance of domestic equities. However even on a longer time scale the under-performance is easy to see. Since the start of the financial year the ASX 200 has risen just shy of 8 per cent, well below the Dow Jones which has gained a staggering 23 per cent. Similarly the S&P500 has risen almost 26 per cent, while the techheavy Nasdaq has out-performed, rising over 27 per cent. Even in Europe the London FTSE has gained more than 17 per cent, while the German Dax has managed to eke out an increase of almost 14 per cent. Whichever way you cut it, the under-performance of domestic equities is plain to see.

Why have Aussie shares lagged?

• The level of under-performance certainly seems to suggest that there are couple of factors at play. No doubt the strength of the Australian dollar has played a significant part in the weak result – especially given that around 40 per cent of our market is owned by foreign investors.

• In fact in US dollar terms the MSCI-Australia index has gained 32 per since the start of the 2010/11 financial year – clearly highlighting the strength of the currency. However since the start of 2011 the MSCI Australia index in US dollar terms has under-performed the MSCI World (ex Australia) index, also in US dollar terms, despite the fact that the currency has effectively tracked sideways. This would suggest that overseas investors have been trimming positions of Australian shares.
• The uncertainty surrounding government policy is also clearly a driver of lack of overseas interest in domestic equities. The contentious debate about both a carbon and mining tax has added a further element of uncertainty to the economic landscape and as such overseas investors remain on the sidelines or are choosing to invest elsewhere.

• Another reason for the weakness in domestic equities has been the fact that both domestic investors and fund managers have been spoilt for choice. The Reserve Bank’s rapid rate hikes last year and the intense competition for domestic funds by the major banks has resulted in very attractive term deposit rates, carrying virtually no risk. In fact superannuation fund holdings of cash assets were at record highs $162.9 billion in the September quarter 2010. And the proportion of super fund’s assets held in cash was 15.4 per cent in the September quarter, well above the decade average of 9.2 per cent. Domestic, risk-averse investors have been attracted by the high rates on offer, diverting funds away from equity markets.

Sector winners & losers

• While domestic equity markets have under-performed in a global sense, the weakness has not been broad-based with only seven out of the 21 sectors recording losses since the start of the 2010/11 financial year. Telecommunications has been the weakest sector, down 17 per cent, while on the flipside Auto & components has recorded the strongest gains, up 23.1 per cent. Notably, given the global cyclical recovery that is taking place, energy, material and resources stocks have also recorded healthy gains.
• Earlier this year the gap between the All Ordinaries index and S&P/ASX 200 was at its widest in 30 months, standing at 110 points, but this has since eased to 95 points. So what does it all mean? Essentially it highlights the fact that smaller companies have been driving our benchmark indexes higher while the ‘big caps’ have been taking a breather. Over the past six months the Small Ordinaries index powered higher by almost 22 per cent while the ‘big cap’ ASX50 index lifted just 6.8 per cent. In part, the out-performance of small caps suggests an underlying confidence in the market. However it also occurred at the same time that the Aussie dollar lifted sharply, making Aussie big cap companies less competitive for global fund managers.
• As the Aussie dollar eases in coming quarters and the global recovery builds momentum it is likely that the larger capitalised shares will once again be outperform “small caps” especially given the continued improvement in corporate profits.

Corporate earnings

• The latest earnings season highlighted the fact that corporate Australia is primed for growth. In aggregate, the ASX 200 companies that reported their half-yearly results had earnings up 25 per cent on a year ago with cash on hand up almost 24 per cent. And when you add in the companies reporting full-year earnings, cash on hand at the 152 companies stood at $102.5 billion, up 25 per cent on a year earlier. In short, Aussie companies have cut debt and lifted cash levels to ensure that they are well prepared to meet the difficulties ahead – and there are a few. The Aussie dollar is still high, making life difficult for exporters, import-competing businesses, global companies and retailers. Then there are the vagaries of the weather, providing further challenges. Consumers still won’t spend. And raw material prices remain at lofty levels.

• Overall company profits are still outpacing share prices. The gap should close by share prices lifting to meet the higher earnings, but of course the difficulty is working out when, and how quickly, this will occur. CommSec believes that a combination of solid earnings and a lower Aussie dollar will serve to drive the sharemarket higher in the second half of 2011 – especially given that the second half of the year is expected to be the growth driver for the economy.

Valuations

• In light of the fear-driven sell-off on global sharemarkets in response to the crisis in Japan, it is always useful to come back to fundamentals. We have assessed 12-month forward price-earnings ratios for a raft of markets across the globe provided by FactSet.
• Of the 70 regions assessed, only 14 have PE ratios that are higher than their 5-year averages. For the “world” market, the current PE ratio of 13.61 is almost 10 per cent lower than the decade average and stands at a seven month low. Interestingly the most under-valued region is Austria with the PE ratio 64 per cent below the 5-year average. More understandable is the next cheapest – Japan – with the forward PE ratio (15.28) more than 53 per cent below the 5-year average.
• The forward PE ratio for the Australian market stands at a seven-month low of 12.8, which is well below the 5- year average of 14.5. Now clearly with investors far more conservative across the globe, the current lower PE ratios may prove the “new normal.” Unfortunately we won’t know the answer on this one for some time.

Outlook

• Looking forward our currency strategists expect the Aussie dollar to ease over the rest of this year falling to around US92 cents by end year, largely due to the increasing perception of US interest rate hikes down the track. A weaker Australian dollar will certainly be an added incentive for foreign funds looking to invest in our share market. And also it will be much more supportive of merger and acquisition activity given valuations will be cheaper.
• The Reserve Bank is likely to remain on the sidelines over the next few months given that the domestic economy has certainly lost some momentum in the short term. The floods have robbed the economy of much need momentum at a time when the multiple rate hikes were already taking a toll consumer activity. As such CommSec anticipates the Reserve Bank is likely to hold off on interest rate hikes in the near term, a further support for equity markets.
• CommSec believes that a combination of solid earnings and a lower Aussie dollar will serve to drive the sharemarket higher in the second half of 2011. However given the near term weakness and the impact of left field events like the Japanese nuclear crisis and unrest in the Middle East, we have revised down our forecasts modestly. We now expect the All Ordinaries/ASX 200 to lift to around 5,200 points by end year.