The swing factor: value returns to Aussie shares

The realisation that the credit crisis has spread to the main economies of the world sent equity markets into a tailspin in the second half of 2008.

While belated government interventions may avert an even worse financial catastrophe, markets around the globe are now facing the sobering prospect of a severe recession.

And after 17 years of economic expansion, there is growing concern the Australian economy will suffer the same fate — a concern that is causing chaos in our own share market.

While local investors were willing to shun financials from the early days of the credit crunch, there was a long-held belief that China would be able to sustain its strong economic growth, in turn underpinning commodity prices, business investment and the share prices of our mining companies.

But China has since shown that it, too, is not immune to the global slowdown. And while China may be continuing to grow, it’s no longer at a pace that can sustain buoyant commodity prices.

As a result, the threat of a global slowdown has resulted in a sharp sell-off in the resources sector, which fell more than 44 per cent in the December half.

The sell-off brought the performance of resources back to the pack after significantly outperforming in the early stages of 2008 (see chart below).

CHART 1: PERFORMANCE FINANCIALS VS RESOURCES (JAN-DEC 2008)

Competing forces

Since peaking in November 2007, the Australian share market has suffered one of the worst bear markets on record, falling around 42 per cent in 2008 alone.

What’s more, ongoing volatility with large share price movements on a daily basis would suggest that it may still be premature to call the bottom of the market. Nonetheless, valuations look compelling at these levels, with many stocks and sectors trading at long-term lows.

The key issue for investors to consider now is the additional earnings risk from the slowing domestic economy, continued weakness in commodity prices and the longer-term implications of the global financial meltdown.

However, this needs to be weighed against increasingly attractive valuations for equities.

According to Goldman Sachs JBWere research, the prospective price-earnings ratio (PER) multiple for industrials is at its lowest level in 13 years.

Moreover, many equities are now trading at record discounts to their discounted cash flow (DCF) valuations.

The key risk to both resource and industrial earnings forecasts over the next 12 months continues to be a worse-than-expected global slowdown, combined with a failure of the US and other governments around the world to thaw capital markets.

Tough times ahead for resources

The decline in base metals prices, such as copper, nickel and zinc (see chart 2), has severely impacted the prices of some ‘pure-play’ stocks, including Alumina, Kagara, and copper junior Equinox.

CHART 2: PERFORMANCE OF COPPER, ZINC, ALUMINIUM (JUN-DEC 2008)

Against a backdrop of slowing growth, forecasts are still being pared back on base metals for much of 2009.

While production costs are falling, it is likely that lower prices will cause cancellations of some new projects and expansions. Should China resume its demand growth in the future, tighter supply may see commodity prices recover somewhat, but this is unlikely in the short term.

Meanwhile, falling spot prices for bulk commodities (eg, iron ore and coal) have tipped the scales in favour of buyers at the expense of our miners in the lead-up to annual price contract negotiations.

The iron ore spot price has moved from a large premium to a discount in a short space of time, hurting the share prices of companies like Fortescue Metals and Mt Gibson Iron, as well as the diversified majors BHP and Rio Tinto.

After securing a record 85 per cent price increase in the 2008-09 negotiations, expectations are for falling prices with Chinese and Japanese steelmakers demanding a record 40 per cent cut in iron ore prices. Coal stocks have been similarly impacted.

Although resource stocks will benefit from the declining Australian dollar, this will not be enough to fully offset commodity price falls.

Industrials in ‘fair’ form

Surprisingly, industrial stocks have seen a small up-tick in earnings forecasts, primarily resulting from the sharp depreciation of the Australian dollar, which is a positive for companies with offshore earnings exposure. Nevertheless, significant downside risks still exist and may offset this currency influence.

The Federal Government’s $10.4 billion and secondary $42 billion stimulus packages, coupled with the Reserve Bank’s slashing of interest rates, down to 3.25 per cent in February 2009, is designed to provide a shot in the arm for the local economy.

But whether these measures succeed in stimulating consumer spending remains to be seen, given many Australians are still reeling from the widespread wealth destruction from share market falls and declining house prices. Despite this, initial indications are that the $10.4 billion package has buoyed retail spending.

Bargain basement financial stocks

The banks are beginning to look cheap, even after accounting for prevailing growth and bad debt risks.

Indeed, the demise of many non-bank lenders could certainly play to the banks’ advantage in the future, with the lower level of competition enabling the bigger players to not only increase the size of their loan books but also their margins, which came under pressure in earlier years.

The Commonwealth Bank recently acquired a 30 per cent stake in Aussie Home Loans, while Westpac swooped on RAMS, picking up the franchise quite cheaply after it became an early victim of the credit crunch. The merger with St George was also deemed a positive, giving the bank significant scale for the future.

More recently, all the majors have moved to raise equity, bolstering their already high tier 1 capital ratios, and have raised over US$60 billion on the international wholesale markets (aided by the Federal Government’s guarantee).

Increasing re-intermediation as a result of reduced wholesale lending in credit markets will also be a positive for the sector.

Has the market bottomed out?

Long-term valuations are beginning to look attractive, and with cash rates coming down, the potential for accumulated cash and term deposits to be reinvested into equities some time in 2009 is rising.

Despite some evidence that credit markets are responding to broad-based global government initiatives, it will be some time before confidence is fully restored. Furthermore, as the prevailing economic outlook continues to deteriorate, further earnings downgrades can be expected until they meet levels more attuned to a recessionary environment.

Historically, the Australian market turns the corner when earnings stabilise, which is unlikely until the second half of 2009.

The reporting season has so far been a tale of mixed fortunes. From the 32 companies to have reported second-half earnings (at the time of writing), eight reported positive earnings surprises with only nine reporting below consensus results.

These figures are encouraging relative to most overseas markets.

However, with the market trading below 3,500 on the benchmark S&P/ASX 200 Index (at the time of writing), this does suggest that a large amount of pessimism is already priced in. This also suggests that Australian equities represent excellent value on a three-year view.

As always, Zurich Investments’ preference remains to invest in companies with robust balance sheets and strong, reliable earnings.

Matthew Drennan is the director of investments at Zurich Investments.