Share market sweet spot - smooth sailing until 2011?

Share markets are currently in the 'sweet spot' and will benefit from higher profits early in 2010, writes Stephen van Eyk.

The near collapse of the global financial system in 2008 — and subsequent massive monetary and fiscal rescue mission in 2009 — saw markets boom 50 per cent from undervalued levels and governments around the globe ‘buy time’ by increasing disposable income for consumers.

These household cash flow surpluses stemmed mainly from low interest rates (reducing debt repayments), social security and transfer payments, reductions in income taxes and insurance company payouts as employment decreased.

Since disposable incomes were held up with government assistance, 2009 saw savings rates begin to increase as people lowered their debt.

But consumer expenditure (although reduced) was better than expected as well in many countries.

As companies ran down inventories to meet demand, company profits began to rise.

Eventually governments will ease up on government payments and disposable income will have to rely on salary increases.

For large companies the biggest advantage of the government’s massive liquidity injections into the markets has been to allow them to raise finance through issuing debt and equity, and has given them the time to lower their costs to meet the new (debt unassisted) consumer demand levels.

Smaller competitors, or those with higher leverage and costs, may have gone bankrupt — leaving fewer companies to gain larger market share and increased profitability.

Companies will continue to experience strong profit rises in 2010 due to the factors listed above.

The average profit increase for Australian companies in the year following a market recovery has generally been about 20 per cent, particularly when rising commodity prices have been experienced, while the average for US companies has been about 15 per cent over the same period.

But because interest rates are unlikely to fall in 2010, further P/E re-ratings are unlikely to be achieved. As a result, further market rises will largely come from earnings and should be limited to about 15—20 per cent.

Since markets continually look forward to determine appropriate valuations, the first half of 2010 will probably represent the ‘sweet spot’ for markets — and things will become more volatile as 2011 approaches.

Another factor adding to the rise in markets in 2009 was the switch from cash and fixed interest investments to equity investments that took place due to falling interest rates (equities became relatively more attractive).

As monetary authorities, particularly in the US and Europe, bought massive amounts of fixed interest paper from consumers to inject cash into the system, this cash was invested into equities.

In effect, monetary authorities financed part of the rise in equity markets and probably went too far.

Although US and European governments are still engaged in quantitative easing policies (printing money) and are unlikely to raise interest rates soon, this switching effect will gradually fade as the year goes on and stock markets will get less attractive relative to bonds.

On the subject of government expansionary policies, 2009 saw Greece and Spain both suffer ratings downgrades on their sovereign debt, Dubai saved from an embarrassing default by a government-owned enterprise (Nakheel) and Japan becoming embarrassed by its public sector finances.

Many countries will gradually phase out their expansionary policies.

All good things come to an end, and 2011 should see a difficult equity market as a number of one-off factors contributing to the market’s rise begin to fade.

A good way to look at the next few years would be to say that equity markets will probably increase by about 30 per cent, but half of it will occur in 2010 with moderate returns later on.

The markets will be concerned with inflation in the second half of the year, and an over-supply of government bonds will see interest rates begin to rise.

The Australian cash rate will hit at least 7 per cent in 2011 (maybe more) and China will apply the brakes to its production boom (and Australia’s commodity boom with it) some time this year.

The Australian dollar has benefited from rising cash rates in Australia relative to the rest of the world in 2009 and stronger commodity prices due to China’s expansion.

This should continue in 2010 until China’s economy begins to cool and rates rise overseas — however, this will be in the second half of the year.

Markets will be torn between lower government support stemming from both fiscal and monetary policy, continuing de-leveraging from consumers (which will be erratic in its effects on consumption), rising interest rates and continued profits from earlier cost cutting.

The good news is that governments are unlikely to tighten fast enough to cause a significant downturn in growth, and stock markets are unlikely to crash again in the near future to any significant degree (having recently experienced a massive downturn).

Diversified portfolios will continue to reward investors this year, and active management will add value as markets absorb conflicting signals as the year goes on.