CPD: Forward view for Australian equities and LICs

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What are the features affecting Australian equities and listed investment companies?

Forward view for Australian equities and LICs

This is the second in a series by Ross Barker, Managing Director of Australian Foundation Investment Company (AFIC), looking at features affecting Australian equities and listed investment companies (LICs).

While part one followed the trajectory of performance in the Australian share market, part two looks at local and global factors affecting the Australian share market and the medium to long term outlook for LICs and Australian equities.

Australia’s business and investment community is currently operating in an environment of low wage growth, low interest rates and technological disruption. The other critical element is the current political landscape which is making it difficult to put in place long term policy frameworks. These factors will inevitably influence future financial, economic and investment landscape in Australia. Against this backdrop, several industry sectors in Australia are currently trading close to, or at the top of their long-term valuation ranges.

Given the above factors, the overall outlook for Australian equities and industry sectors in the medium term remains somewhat mixed.

Features affecting business and investment sentiment in Australia

Interest rates

The U.S. Federal Reserve has indicated it will gradually increase interest rates over the coming years in a slow-growing but durable economy. It has already increased the official interest rate to 1.25 per cent following three modest rate rises in six months to June 2017 and has indicated it will make one further increase in the second half of 2017. Longer term, U.S. interest rates are projected to trend higher.

In contrast, the Reserve Bank of Australia (RBA) is likely to keep interest rates on hold at 1.5 per cent for the medium term to help minimise any risks associated with strong residential property prices. Any major correction in prices would clearly reduce household wealth, with an attendant impact on consumption and the construction sector.

It will be a significant balancing act for the RBA to deal with high property market values and the heightened level of household debt. In the long term, it is likely to approach any rises in interest rates with extreme caution given these circumstances. 

Growth projections for Australia

Economic and population growth projections are supportive of long term interest rate rises. Economic growth is expected to increase gradually to almost 3 per cent per annum by 2018[1] with the population expected to reach 25.6 million by 2020.

Impact of technology disruption

As new business models emerge from the use of the internet and development of smart software solutions, there is likely to be a continued rise in companies coming to the market as well as offshore companies listing on the ASX. There are a number of technology businesses in the embryotic stage that investors will be watching closely.

The future impact of technology disruption for the Australian market remains mixed for different industry sectors, with consumer-facing sectors likely to face higher risks in the shorter term.

Federal and state government policy setting

A recent survey indicated almost 40 per cent of company directors identify uncertainty around policy, political instability and lack of long-term vision as key issues affecting confidence[2]. Heightened taxation risk from federal and state governments in an environment where budgets are under pressure has also become a feature of the Australian economy.

Although reform is challenging for the Federal government, a well-considered, comprehensive approach to taxation and budget reform will be vital to create a more robust foundation for the Australian economy.

Energy policy

Energy policy setting in Australia has been inconsistent for the last decade, ultimately resulting in challenges for suppliers and higher electricity prices for households and industry.

Future sustainability of the energy sector is dependent on a careful balance of setting policy and rising costs of energy, managing future demand for resources and the gradual move to a greater use of renewable sources.

Household debt

High levels of household debt against subdued wage growth is producing a weaker outlook for discretionary consumption. This will affect the retail sector in the medium to long-term, which also faces future competitive challenges from Amazon’s imminent entry to the market and with global supermarket chains already challenging Coles and Woolworths’ dominance.

Change in commodity prices

The recent strength in commodity prices has come on the back of increased infrastructure spending, greater real estate investment and reduced coal production in China, as well as reduced supply across a number of commodities over very recent times as investment was withdrawn. Demand from the steel industry in China for quality iron-ore also remains strong. As we have seen already this will benefit earnings growth for top quality producers including BHP and Rio.

However, there are indications that the Chinese Government plans to renew its long term economic shift from heavy industry to services which could affect demand in the future.

While commodity prices aren’t expected to stay around current levels, global growth remains supportive of commodity prices over the medium to long term.

Australian property prices

Any disruption to the highly-geared household sector may affect future earnings growth for the banks. Banks are already facing increased capital requirements and higher lending standards have been imposed.

Amazon’s arrival may create headwinds for the REIT sector if shopping centres become challenged to secure tenants and maintain rental growth. This will be an even more difficult task for less prominent retail centres.

There are also concerns around the compounding impact from a slowdown in construction, which may lead to higher unemployment levels in both construction and the broader real estate sector.

National Broadband Network (NBN)

The implications of the NBN will likely create headwinds for Telstra and the telecommunications sector more broadly as consumers seek out competitive deals and as the mobile market becomes open to new providers.

Geopolitical concerns

Tensions in the Middle East, the economic implications of Brexit for UK and Europe, uncertainty around the Trump Administration’s long-term legislative agenda and growing concerns surrounding North Korea will impact investor confidence at different stages. This could lift market volatility at least in the short to medium term.

New economic powers

China and Russia continue to look for opportunities to disrupt the United States’ preeminent geo-political position which will also contribute to global volatility.

Further, regional gross domestic product (GDP) projections to 2026 show large developed economies are becoming less significant while emerging economies continue to gain economic influence[3]. Although pressures remain in all emerging markets, overall GDP growth is expected to average 3.7 per cent between 2017-2021 and settle on a trend growth rate of 3.5 per cent between 2022-2026.

Despite its economy slowing, China growth is projected to hit 6.7 per cent GDP in 2017, 6.3 per cent per annum by 2020 and 5.8 per cent per annum by 2022. [4]Projections are even stronger in India, with GDP of 7.2 per cent per annum between 2017 and 2018 and a medium-term outlook of GDP growth above 8 per cent, following the adoption of the Goods and Services Tax (GST) [5]

This compares with a 2.1 per cent projected GDP growth per annum for the United States in 2017 and 2018, with longer-term projections of 1.8 per cent GDP growth per annum.[6].

Many Australian companies have been growing their businesses offshore for some time. This has helped diversify away from lower growth jurisdictions such as Australia to higher growth markets, including China. Some examples – which AFIC is invested in – include CSL, Amcor, James Hardie industries and Cochlear.

Continued support for LICs

The growing SMSF sector, alongside the future of financial advice (FOFA) reforms and low returns on cash and term deposits is one of the reasons for the 98 per cent increase in LIC listings between June 2013 and March 2017.

The sector has experienced a ‘renaissance’ in the last five years. While LIC sector growth can be cyclical in nature, the recent trend in AFIC shareholders growth at eight per cent per annum supports the view that the listed investment vehicle will remain popular among income-focused retail investors in the medium to long-term (five to ten years) as a way to access different asset classes in the current low interest rate environment.

Outlook for Australian equities

History has shown that good quality companies will deliver sound investment returns over the long term. These companies typically have good positions in attractive industries, sound balance sheets and have quality management. Importantly, one of the key decisions that will influence returns is the price an investor pays for the shares in companies. This is something we are very mindful of.

The long-term returns of the Australian share market are approximately 6.5 per cent capital and 3.5 per cent yield. Although these figures may not be as high in the future, given low growth and interest rates, it’s our view that over the next five to 10 years, Australian equities will continue to provide retail investors with sound returns, including good income returns.

As a long-term investor, it’s our role to analyse how Australian companies are managing the challenges that arise and look for opportunities to invest at the right time to create a low cost, diversified portfolio for the benefit of our shareholders, and which will grow dividends in real terms over time.

 

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[1] Organisation for Economic Co-operation and Development: http://www.oecd.org/australia/australia-economic-forecast-summary.htm
[2] Australian Institute of Company Directors, Director Sentiment Index (December 2016): http://aicd.companydirectors.com.au/advocacy/research/director-sentiment-index-second-half-2016
[3] The Conference Board: https://www.conference-board.org/press/pressdetail.cfm?pressid=6899
[4] International Monetary Fund: http://www.imf.org/en/News/Articles/2017/08/09/NA081517-China-Economic-Outlook-in-Six-Charts
[5] International Monetary Fund: http://www.imf.org/en/Publications/CR/Issues/2017/02/22/India-2017-Article-IV-Consultation-Press-Release-Staff-Report-and-Statement-by-the-Executive-44670
[6] International Monetary Fund: https://www.imf.org/en/Publications/WEO/Issues/2017/07/07/world-economic-outlook-update-july-2017

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