Insights

If you have a large stockmarket shock as we have had in the last couple of days, the market will vary in a broad range in order to discover the prices that people want to buy at and sell at.

Market clearing is important. If markets always went up, no one would ever sell. There would be no supply of stock and the market would never clear itself. That's why corrections are really important.

When we go into periods of big volatility like this, it is the amount of liquidity in the US wholesale system that decides how long that period of volatility will last.

I think this period will last weeks rather than days. I think by the time we get to the end of March and into April, the amount of volatility will be absorbed and the market will be returning to its normal buoyant self.

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We are in a period like 2006 where there is a very large amount of US corporate liquidity. We can tell that because the spreads between US corporate debt in the US wholesale market and sovereign debt have fallen to the lowest levels since 2006. So there is a vast amount of liquidity and that is providing a lot of money to the stock markets.

If I value the Australian stock market in terms of earnings per share and bond yield right now I get a value of around 5700 points. But if I include the additional supply of US corporate debt in the US wholesale market to a model, I get a fair value of 6300 points. I think that estimate is what is appropriate right now. I think that our market right now is hundreds of points too cheap.

When we came into this correction, the US market was about 9% too high including all of the factors I've just spoken about and the Australian market was about 4% too low.

That is because the US market is extending a run towards the end of its cycle whereas we are starting a new cycle based on the improvement of commodity prices.

We are going through a period of high volatility. Because of the size of that volatility I think it will take weeks to clear and not days. By the end of March we will be out of this period.

When we come out of this period we should realise we are in a period of a huge amount of US corporate wholesale liquidity which will continue to bid up markets. My fair value of the Australian stock market including that liquidity is 6300 points. This means that when this volatility eases we will be in a market which is hundreds of points too cheap.

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On track for a solid season

The first half reporting season kicks off later this week, and according to the latest Thomson Reuters earnings estimates, EPS for the S&P/ASX200 is forecast to grow by 7.0% in FY18, down from the 11.3% in FY17.

This pace of growth is forecast to continue over the following two years (FY19: 5.9%, FY20: 5.2%) providing a platform for steady equity returns, with stronger global growth and improving business conditions offering the upside.

In our view the sectors best placed for upside surprise this reporting season include Resources, Offshore Earners and Retailers.

Key points

• Positive business and consumer sentiment sets the tone for the February reporting season and investors have responded by putting capital to work.
• Since August results, already extended growth stocks have further re-rated against a backdrop of US tax cuts, low inflation and low volatility. This cannot occur indefinitely and company results typically provide the reality check that investors need to recalibrate their expectations. We think growth stocks risk underperforming in February.
• The European resurgence and the Trump-led economic reforms in the US are poised to continue to buoy ASX offshore earners (Corporate Travel Limited, Reliance Worldwide, Apollo Tourism). While Australian economic growth is improving, offshore markets continue to set the pace for an economic rebound. We expect to see companies further clarify the extent of the US tax reform benefits via their results.

Valuations set a high bar for market darlings and growth stocks

Elevated valuations will again set a high bar for growth stocks and unless earnings upgrades are likely, we prefer to err on the side of caution and take profits where we think prices have run ahead of fundamentals.

We look for evidence that improving business and consumer sentiment is beginning to translate into meaningful earnings tailwinds for businesses.

What concerns us is the magnitude of the divergence between high PE and low PE industrial stocks. The spread is the widest it's been in five years, and we think February will be the reality check the market needs to bring valuations back into line.

We prefer industrial stocks where we identify upside risk to earnings and guidance (Corporate Travel Limited, Reliance Worldwide, JB Hi-Fi).

Counting on a capex turnaround

The Australian corporate environment is witnessing evidence of some positive earnings trends driven by the rebound in commodity prices and better operating conditions. Until recently capital spending had been conspicuously absent from the rebound.

That has changed, and with the improving earnings environment and high levels of business confidence, we believe capital expenditure could continue to grow, which could strengthen the earnings expansion and help reverse declining growth in productivity.

Commodities recovery doing the heavy lifting

The Resources segment is enjoying EPS growth of 15-20% while Industrials growth is tepid at 6-7%. Arguably the Industrials side of the market, which is trading on elevated valuations, is in part trying to pre-empt the flow through of higher Resources earnings into the economy.

Higher dividends are a certainty in February (in line with dividend policies) with dividend upside risk driven by the fact that key commodity prices (oil, iron ore, coal) have traded well above consensus expectations through late 2017.

In our view, the bulk commodity miners (BHP, Rio Tinto, Fortescue Metals, Whitehaven Coal) offer best upside capital management potential.

Morgans clients receive access to detailed market analysis and insights, provided by our award-winning research team. Begin your journey with Morgans today to view the exclusive coverage.

An end to the earnings drought

FY17 reporting season kicks off in earnest mid-August and according to the latest IBES consensus earnings estimates, EPS growth for the S&P/ASX200 is forecast at 13% in FY17, slightly down from 13.6% at the end of 1H17. Pleasingly this would still mark the end of the earnings recession after two straight years of contraction. We are confident that the improvement in the economic outlook will translate to earnings over the next 12-18 months so long as the positive conditions are reflected elsewhere (outside of Resources). With this in mind, we think outlook commentary and how management chooses to deploy capital may be as important as reported numbers.

The growth versus value conundrum

The prospect of policy gridlock in the US and low levels of global wage inflation have again resurfaced dis-inflationary fears. This has prompted investors to seek safety in the quality and yield trades that have been so profitable for many over the past two years. Valuations therefore remain extended and the divergence between 'growth' and 'value' stocks has again widened. High valuations make for high expectations. We are wary of high PE stocks with even the slightest earnings risk (CSL, DMP, COH) – as demonstrated through the May 'confession' season, stocks that miss the mark continue to underperform. The PE divergence also presents opportunities in overlooked areas of the market where we see earnings upside potential (LOV, JBH, CLH).

Turning 'soft' data into earnings

While a lot has been said of the weak growth in the Australian economy in Q1 2017, forward-looking indicators of business activity continue to indicate broad expansion in activity. After a prolonged period of cost-out and consolidation, it is encouraging to see a sustained pick-up in business conditions and sentiment which we expect to translate into an improvement in earnings. The translation of improving 'soft' survey data into earnings growth is necessary to support the high valuations commanded by the market. Falling payout ratios suggest that, perhaps, corporate Australia is finally ready to revive capital expenditure and investment in growth.

Morgans surprise or disappoint candidates

We highlight our key candidates that may surprise or disappoint during the upcoming August results season:

• Potential earnings surprises – Amcor (AMC), Reliance Worldwide (RWC), JB HiFi (JBH), Lovisa (LOV), Webjet (WEB), ResMed (RMD), Bapcor (BAP)
• Likely to see positive outlook statements – Ramsay Healthcare (RHC), Healthscope (HSO), Collection House (CLH), Sirtex (SRX), EBOS (EBO)
• Potential for positive capital management – BHP (BHP) and Rio Tinto (RIO)
• Potential earnings disappointments – Coca-Cola Amatil (CCA), Blackmores (BKL), Pact Group (PGH), Admedus (AHZ)
• Possible soft outlook – Telstra (TLS), TPG Telecom (TPM), Cedar Woods (CWP), Mantra (MTR)
• Vulnerable high PE stocks – Ansell (ANS), CSL (CSL), Cochlear (COH), Domino's (DMP)

Morgans clients receive access to detailed market analysis and insights, provided by our award-winning research team. Begin your journey with Morgans today to view the exclusive coverage.

• The Budget balance is set to improve at a steady rate. This will reassure the rating agencies.
• The understanding that house prices can be brought down by increasing supply has been suggested previously by the RBA. This Budget provides policies based on that insight.

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In more detail

Increasing Housing Supply

This Budget shows that there has been considerable development of policy detail over the last year. An example of this is in the housing sector. We have commented previously on RBA Governor Phil Lowe’s speech in Melbourne in which he pointed out the problem of house prices is a problem of under supply.

This under supply was in turn a problem of underdevelopment in infrastructure, particularly transport infrastructure.

This Budget approaches this issue in a number of ways. Firstly, there is increased investment in Urban Infrastructure, particularly Transport Infrastructure. Secondly, there is an approach towards investment incentives to increase the supply of housing.

For example, the Commonwealth will replace the National Affordable Housing Agreement that provides $1.3 billion every year to the States and Territories, with the same level of funding but requires the States to deliver on housing supply targets and reform their planning systems.

In addition, there is a $1 billion Housing Infrastructure facility to fund City Deals that remove infrastructure impediments to developing new homes (City Deals involve Federal government loan money provided to municipalities.

This money is paid back in the long term by a very small increase in city rates). One of these City Deals will be in Western Sydney. This should help to deliver tens of thousands of new homes.

In addition, the capital gains tax discount is increased to 60% for investments in affordable housing. This will increase investment in affordable housing and increases supply.

These policy initiatives are much more intelligent than others which sought to increase taxes on investment in housing. These initiatives would have reduced the supply of housing.

The Big Bank Levy

This Budget introduces a six basis point levy on big banks liabilities. Six basis points is 0.06%. This bank levy appears to be based on the model used in the UK. The forward estimates suggest this will secure $6.2 billion for this Budget and future Budgets.

These kinds of levies assume that the big banks are in a position of non-competitive advantage where they can generate excess profits.

Infrastructure

The Budget is remarkable for the number of infrastructure initiatives. The Western Sydney Airport Corporation is provided with $5.3 billion in equity over the next ten years. $10 billion is invested in a National Rail Program.

Programs in Adelaide, Brisbane, Melbourne and Sydney all have the potential to be supported through this program (subject to a proven business case). $8.4 billion will be invested in the Melbourne to Brisbane Inland Rail Project.

Construction of this 1,700km project will begin in 2017/18 and support 16,000 jobs at the peak of construction. The project will benefit all of the regions along its route.

Fiscal outlook

In Chart 1 above we see receipts and payment for the Australian general government sector over the period from 1999/2000 up to and including 2019/2020. The chart shows us the extraordinary expansion spending in 2009/2010 and the slump in revenue at the time of the Global Financial Crisis.

The struggle has been in recent years to get the Budget back into the kind of balance that it was before the Global Financial Crisis.

The path of the move back to balance is remarkably similar to that of last year’s budget papers. This must be calculated to support the confidence of rating agencies. In 2017/18, receipts are expected to be 23.8% of GDP. This moves up to 25.1% of GDP in 2020.

Payments in 2017/18 are 25.2% of GDP. The Budget Papers suggest that this will move sideways to 25.0% of GDP in 2019/20. This generates an improvement in the underlying cash balance. This balance is shown in Chart 2.

The underlying cash deficit in 2016/17 is estimated to be 2.1% of GDP. This eases to a deficit of 1.6% of GDP in 2017/18. By 2019/20, the Budget should be in balance with a deficit of only 0.1% of GDP. The following year sees a small surplus of 0.4% of GDP.

Where the money is going

In Table 1 above, we can see where the money is going. In 2017/18 the largest single sector of expenditure is Social Security and Welfare. $164 billion or 35.3% of the Budget goes to this area. Other Purposes is the next sector.

What, you ask, are other purposes? This sector is the amount that we pay on servicing the debt for the money we previously spent. This is 20% of Budget expenditure. It is a total of $92.8 billion.

Next comes Health. Here we spend $75.3 billion or 16.2% of the Budget. Education comes next with $33.8 billion of expenditure. This is 7.3% of total spending. Only then do we think about defending the country. Here, we spend $30 billion a year. This is 6.5% of the Budget.

It is worth observing that we spend five times as much on Social Security and Welfare as we do defending the country.

The Economic Outlook

Budget Paper No 1 suggests that the Australian economy is recovering. Treasury expects 2.75% growth in 2017/18. This increases to 3% in 2018/19 and remains at that level for the next three years. This is slightly less optimistic than the outlook provided by the International Monetary Fund. The IMF sees growth moving forward at about 3.1%.

The Budget papers show unemployment of 5.75% in 2017/18. This unemployment rate then stabilises at 5.5%. We think this is a reasonable estimate of where unemployment is going. Still, we remark that the IMF is far more optimistic. The IMF sees unemployment declining to 5% and lower over the next few years.

The CPI is expected to increase by 2.0% in 2017/18. It then increases to 2.5% by 2019/20. These kinds of estimates of future inflation are similar to those of the RBA. We do not think that any of these estimates are too optimistic.

Compared to the IMF, for example, the outlook contained in the Budget Papers is modestly conservative.

Conclusion

The Budget balance is set to improve at a steady rate. This will reassure the rating agencies. The assumptions upon which the Budget is based cannot be described as too optimistic. In fact, they are modestly conservative.

What we see in this Budget is a rare example of thoughtful policy development at a detailed level. The investment in infrastructure is much to be commended.

The understanding that house prices can be brought down by increasing supply has been suggested elsewhere by the RBA. That politicians can bring forward policies based on such correct insights as we see in this Budget, seems in Australian politics, a sadly rare event.

Morgans clients receive access to detailed market analysis and insights, provided by our award-winning research team. Begin your journey with Morgans today to view the exclusive coverage.

Equity markets remain at the mercy of abnormal macro-economic conditions such as unconventional central bank interest rate settings and heightened political uncertainty. Making bold portfolio decisions amid such uncertain conditions is a difficult and potentially hazardous exercise; hence our cautious Asset Allocation settings.

Despite these challenges, we think that enduring investment themes are worth following in the year ahead. These themes help frame our Asset Allocation strategy, and we highlight these (and the best stocks to leverage them) below:

Our ten key investing themes and how to play them

1. A US cyclical recovery drives interest rates upwards – QBE Insurance Group (QBE), Computershare (CPU)
2. Rising domestic energy prices – AGL Energy (AGL), Infigen Energy (IFN), Senex Energy (SXY)
3. Resources cashflow resurgence – BHP Billiton (BHP), Rio Tinto (RIO), South32 (S32), Oil Search (OSH)
4. Diversify internationally – our recommended LICs and ETFs
5. Inbound tourism – Sydney Airport (SYD), Mantra Group (MTR), Helloworld (HLO), Apollo Tourism and Leisure (ATL), The Star Entertainment Group (SGR)
6. Rise of the Chinese consumer – Treasury Wine Estates (TWE), Blackmores (BKL), Bellamy's Australia (BAL), The A2 Milk Company (A2M), Capilano Honey (CZZ)
7. Smarter healthcare and the empowered consumer – ResMed Inc (RMD) and Volpara Health Technologies (VHT)
8. Retail disruption and the Amazon threat – Beacon Lighting (BLX), Lovisa Holdings (LOV), Bapcor (BAP), Qube Logistics (QUB)
9. The push for financial deregulation – Westpac Banking Corporation (WBC), US Banks (ASX: BNKS)
10. The digital marketplace – NEXTDC (NXT), Vita Group (VTG), Megaport (MP1)

Morgans clients receive access to detailed market analysis and insights, provided by our award-winning research team. Begin your journey with Morgans today to view the exclusive coverage.