Lonsec’s Head of Equity Research, Bill Keenan, commented, “While Australia has low direct exposure to Europe, it will still be indirectly impacted by financial markets in terms of the cost of wholesale bank funding (still about 40% of the banks’ funding), currency fluctuations and global investor sentiment.”

“In addition, a European recession could indirectly affect Australia via its impact on China.”

“While the European situation remains very uncertain and hard to predict, there are a number of reasons to expect the downside to be limited this time around.”

Lonsec believes there are a number of reasons for this, including:

1. Market lower – the Australian sharemarket has retreated from the 4,500 level rather than the 5,000 level as in April 2010 and 2011, and accordingly, dividend yields are higher and PE ratios considerably lower.
2. Yield curve lower – the RBA has cut the cash rate by 100bp since late 2011 and another 100bp in cuts is expected in the short term. The yield curve from cash to 10 year bonds is falling quite rapidly, which is supportive of economic growth and equity valuations.
3. AUD lower – the AUD has weakened 8% this year, which is taking some of the pressure off Australian exporters and manufacturers.
4. China easing policy – China is progressively easing monetary and fiscal policy to support growth, which is still expected to be around 8%. Back in 2011, it was tightening monetary policy to combat inflation.
5. US economy robust – US retail sales and manufacturing have been solid, while the housing market is showing signs of bottoming out. The US also has a new-found supply of cheap energy in shale gas, which will prove to be important over the medium term. On the negative side, new payrolls have been weakening again in recent months and the US budget deficit is due to be reigned in after the US election in November 2012.

“European issues are complicated and will take time to resolve,” said Keenan.

“However, we remain positive on the medium to long term outlook for the US, Asia and Australia.”

“Given the local market is already low and company balance sheets are strong, we don’t see any reason to be overly negative towards Australian equities.”

Lonsec expects the market to rebound, but it is likely that the rate easing cycle will need to play out fully before the market starts to recover in the second half of the year.

“Stocks with good dividend yield and fairly secure earnings are likely to outperform in the short term,” said Keenan.

“Investors should also target high beta resource and cyclical stocks on market weakness, taking a long term view that global growth will recover, led by Asia.”

Lonsec believes the next positive catalysts for the sharemarket will be:

1. RBA rate cuts
2. Lower AUD
3. China stimulus
4. EU progress
5. Change in Federal Government.

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“Lonsec has had a target of 5,000 for the All Ordinaries Index by the end of calendar year 2012,” said Keenan.

“I believe yesterday’s rate cut by the RBA will fuel this.” “History shows that a period of successive rate cuts nearly always leads to a strong rally in Australian equities.”

There are a number of reasons for this according to Keenan.

“The two most important reasons are firstly, a lower cash rate (and yield curve) lowers the return from cash, term deposits and bonds.”

“Secondly, the cost of debt is reduced which improves the disposable income of households and increases the return on equity of companies.”

In turn, economic growth recovers as consumption and business investment improve and a softer currency (usually) boosts exports. The Australian share market rallies as company profits improve and investors switch out of low yielding cash, term deposits and debt and into equities. Lonsec believes this easing cycle will end at 3.50% and therefore expects cash and deposits to come down by 75 basis points or more (from today) and loan rates to reduce by around 60 basis points.

“When you combine lower interest rates in the Australian economy with an improving global growth outlook, particularly in the US and Asia but also Germany, and Liberal/National governments transitioning back to each State and most probably federally by 2013, the economic and earnings outlook is suddenly a lot more brighter,” said Keenan.

Lonsec stock picks

Income stocks

• Commonwealth Bank (CBA) – best positioned and the most profitable major bank in the Australian market with the most advanced technology platform. Credit growth, superannuation flows and investment returns will recover over the medium term. Buy for yield (6.2% fully-franked) and long-term growth.
• Woolworths (WOW) – defensive with growth, given earnings are 90% food, liquor and petrol; home improvement provides a new growth driver. Has retreated to a good yield (4.7% fully-franked) and cheap valuation (FY13 PER 13.7x). Retail conditions should improve as interest rates come down.

Growth stocks

• Origin Energy (ORG) – has a leading vertically-integrated position in the Australian energy market. ORG’s LNG joint-venture (APLNG) is heavily de-risked after Sinopec (China) agreed to take most of the LNG and 25% equity in the project, but the market is paying very little for it. ORG has plenty of growth levers.
• Computershare (CPU) – the blockbuster BNY Mellon acquisition positions CPU as the dominant share registry company in North America (70% of the S&P500 covered), and indeed globally. CPU should generate double-digit earnings growth over the next few years from acquisitions and an up-tick in the cycle.

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