Paul Xiradis

The world is now in the process of controlling COVID-19 with a range of tested vaccines just over a year on from the original declaration by the World Health Organisation on 11 March 2020 that COVID-19 was officially designated a ‘pandemic’. This is a remarkable achievement even though control of the virus remains a challenge.

We expect to see an acceleration in global growth to 6.6% in 2021, with the US set to grow 7.0% in 2021.

China was the first nation to emerge from lockdown in 2020. China is consolidating growth in the domestic economy and is expected to print an economic growth figure of  8.2% in 2021.

Advanced economies are forecast to grow at multiples of their 10-year average, with Europe emerging from a double-dip recession caused from its second lockdown. Ausbil is expecting  the Eurozone to grow by 4.7% in 2021.

Of all the pandemic stimulus packages, the US was far-and-away the largest, with the level of US fiscal support during the pandemic, so far, totalling US$5.2 trillion, 24.6% of nominal GDP, or three times the fiscal support given during the 2008 financial crisis. In addition, the Federal Reserve’s open-ended QE program is providing monetary support to the tune of 11% of nominal GDP to date. Ausbil’s current economic outlook is summarised below.

Risks

There are a number of risks to Ausbil’s outlook. Recently, markets have been concerned about  a permanent rise in inflation, what the recent rises in bond yields might mean for more persistent inflation, and the risk it poses to interest rate levels.

These fears are also caught up with concerns around any earlier Fed response than expected, or any tapering of QE sooner than expected, that is, before the 2024 milestone, which has been set based on the emphatic and repeated comments by both the Fed and the RBA. These risks are associated with an economic rebound that is too successful, or successful too quickly.

There are three conditions required before there is a lift-off in rates. Firstly, there needs to be a labour       market that is at maximum employment. Secondly, inflation needs to have been at ~2% for at least a year. Finally, the level of inflation needs to be on track to exceed the 2% level “for some time,” as noted by the Fed. These three conditions have never been simultaneously met in recent history.

Another risk is that growth actually underperforms, and the rebound is less than successful due to new COVID variants outpacing the efficacy of the current stable of vaccines. There also remains unquantifiable geopolitical and trade risks around the world, including the potential for regional conflicts in Iran/Israel, China/Taiwan, Russia/Ukraine, and now with actual conflict in the Middle East.

Ausbil’s view is that economies will run ‘hot’ for some time, with the support of policymakers, and are delivering the best growth figures since 1983, across a multi-year growth profile, as illustrated in the table above.

While inflation will remain an ongoing source of worry as the perennial flipside to growth, it is important to understand when inflation spikes are intermittent or if they are moves to a higher sustained level. It is our view, and indeed that of most global central banks, that inflation will not be a problem for some years as the world economy returns to health.

We see inflation remaining within  target ranges for some years, and cash rates on hold until 2024, with long bond yields to adjust over these years in an orderly fashion. Australia’s economic growth, and the current resources boom, will underpin the Australian dollar, with Ausbil forecasting the AUD/USD in an up-trend: 75-80c for 2021, 80-85c in 2022, and 85-90c in 2023.

This low-rate environment, and the multi-year economic growth outlook, is supportive of an underlying multi-year growth outlook for equities, especially in cyclical sectors, banks and in resources as world demand grows.

Earnings surprises

Two key sectors where we see further earnings surprise are the banks and resources sectors.

Banks, which offer primary exposure to a recovering economy, entered the pandemic after heavy barrage from the Hayne Inquiry and having already been sold down. The pandemic saw them sold down further on fears that the recession and COVID job losses would impact their lending books. All the banks provisioned majorly for the potential for credit loss, and APRA further enforced capital retention through limiting the dividends they were allowed to pay. Looking at the banks in the 2021     New Year, it was evident that the bad and doubtful debt experience was nowhere near predictions, and that the banks had over-provisioned for losses. With APRA allowing a return to more commercial             dividend levels, and the economy resurging from the 2020 lows, we could see banks were in a position to reduce these provisions and grow their books further in a renewing real estate market. The result is that over the next few years, the unwind of this over-provisioning will see a rerating of earnings, ahead of the consensus expectation at the time we began up-weighting into banks.

Metals and mining are in the midst of two fundamental themes in global resources investing. The first is the super-cycle demand for Australia’s bulk commodities including iron ore, from China in terms of building and infrastructure demand, and as a function of the growth path of the world economy. This theme is expected to drive earnings in companies like BHP, Rio Tinto and Fortescue Metals. The second is the fundamental shift in the energy transition to renewable energy, and the rapid adoption of electric vehicles, which is sparking a secular demand for bulk, base and battery materials (copper, lithium, cobalt, zinc, manganese and rare earths) that is expected to last for decades, underwriting the fundamentals of a strong resources market. This long secular ‘electrification’ demand is forecast to drive earnings in companies like Galaxy, Orocobre and IGO (in lithium), OZ Minerals (in copper) and Lynas Rare Earths.

Ausbil has been overweight banks and resources (metals and mining) for some time. These overweights remain in place across our portfolios and have driven outperformance across our different strategies. Importantly, we are still in the early stages of the economic cycle, with a positive growth outlook for multiple years that is expected to drive performance in these mega-sectors.

The portfolio is also tilted towards rebound stocks in travel and recreation (such as Qantas and Webjet) whose earnings are returning following the implementation of global vaccinations, as well as high quality industrials and healthcare names (like Ramsay Health Care) which are primary beneficiaries of economic recovery.

Where next?

Since the historic reversal in consensus across the February reporting season that saw the FY21 consensus earnings outlook for the broad market rebound from -1.6% to +15.6%, consensus earnings outlook for both indices has rerated to +19.08% (S&P/ASX 200) and +19.02% (S&P/ASX 300).

While these earnings figures are strong, Ausbil’s house view is that consensus is still under-estimating the rebound in earnings that will occur in the prevailing economic conditions, with rates to remain low, and with the world economy providing a tailwind to Australia’s current expansion.

In terms of the market itself, there are three important observations that can be made when looking at the earnings growth and levels. The first is that the consensus earnings outlook regularly misses the actual earnings by some margin, as illustrated by the blue and red bars in the chart. Moreover, in the expansion phase of 2004-2007, consensus significantly and consistently undershot actual EPS growth. What is interesting about this period is that it shows a multi-year expansion period of year-on-year positive EPS growth that could be similar to the period of earnings expansion we have just entered in 2021.

The second observation is that since the GFC, aggregate earnings have moved sideways, within a range. Market performance has been driven by significant P/E expansion in this time rather than earnings expansion. Ausbil’s outlook is for the return of strong multi-year earnings over the next 2-3 years, and possibly beyond.

Finally, markets are volatile and can rise and fall on anticipated and unanticipated information. However, comparing the market and EPS levels in Chart 3 over time shows that markets tend to rise when earnings are in a rising pattern, or conversely, the market is unlikely to fall significantly when it is in an earnings upgrade cycle.

Ausbil’s portfolios have been positioned for a clear path to recovery, but with some volatility and uncertainty along the way. We are expecting a multi-year earnings growth cycle, and we maintain the position that investors are compelled to participate. While we maintain a positive outlook on earnings, this is still a time to invest in only the best quality companies, which exhibit superior underlying earnings growth and strength, in order to achieve longer-term outperformance.

Comments by Paul Xiradis Executive Chairman, Chief Investment Officer, Head of Equities and Jim Chronis, Chief Economist

The post New financial year outlook for equities: the prospects for multi-year earnings growth appeared first on AdviserVoice.