Cash: Losing the home advantage

Australia did not experience the dramatic downturn experienced by other markets during the global financial crisis, but neither has it enjoyed the massive upswings. This has left Australian equities looking less attractive, writes Caroline Munro.

Despite expectations of a good year for Australian equities at the beginning of 2010, the sector underperformed relative to global shares and is likely to continue to do so through 2011 – albeit to a lesser extent. Yet fund managers are showing an increasingly positive sentiment.

According to the Russell Investment Manager Outlook report, released at the end of 2010, investment managers expected the Australian sharemarket to move higher over 2011, and a third of fund managers were actually “extremely bullish”, Russell Investments portfolio manager Scott Bennett said at the launch of the report.

He noted that at the end of last year, sentiment towards equities had hit a five-year high.

However, Russell does not necessarily share this sentiment, and recently adopted a more bullish attitude about the potential upside of global equities compared to Australian shares.

Russell Investments chief investment strategist for Asia Pacific, Andrew Pease, says the theme for Australia last year was “less pain, less gain”.

“Australia was at a valuation disadvantage relative to the major developed markets because we’d missed out on the recession of the global economy. And because we significantly diluted our sharemarket through issuance, we had less scope to perform as well as other markets,” he says.

“This year we have the same theme, but not as pronounced.”

AMP Capital Investors head of Australian equities, Greg Barnes, agrees that Australia’s lower trajectory slowdown compared to other countries meant its recovery was relatively shallow as well.

“Whereas if you look at the US — which was really the epicentre of the global financial crisis — and if you look at Europe, those markets experienced very substantial losses and a very significant snapback,” he says.

“As a result of that, the earnings revisions that we are seeing in the US and to a lesser extent in Europe are much more significant that what we’re seeing in Australia.”

Portfolio manager of Fidelity’s Australian equities team, Kate Howitt, says investors are realising the rebound in growth in the developed worlds, and are shifting their attention away from Australia.

And while Australia is trading at cheap levels, it is not as cheap as the US and European markets.

“We’ve been the low beta market of the developed markets,” Howitt says.

But Pease is less confident that the home country bias is coming to an end.

He is quite adamant that while he is not bearish on Australian shares, he wants to disabuse people of the notion that since Australia missed out on the global financial crisis it has a bulletproof economy and therefore investors should focus their investments on Australia.

“This idea of home country bias has become more reinforced by the events of the last few years,” he says, voicing the hope that another year of relative underperformance would finally rid investors of that bias. He suspects, however, that it will not.

Performance and opportunities in 2011

While Russell maintains an international equities bias, Pease says Russell is a lot more neutral on Australian and global shares than it was last year.

“This year the Australian market can give you a reasonable return for share — you’re getting a 4 per cent dividend yield,” he says.

“You’re probably not going to see much market appreciation but we’re going to get anywhere between 5 and 10 per cent earnings for it (I think the consensus is 13 per cent earnings growth). And the signs are that when you look at valuations, markets are valued on a fair return on shares.”

He says the last 10 years saw gross returns in Australian shares of about 8 per cent per annum, which he classifies as ‘normal return’.

“I think the market rate now is priced to deliver normal returns in the future, which is fine — it’s a good place to be,” he says. However, Pease maintains that for now overseas markets, including the US, were seeing much more cyclical upside.

AMP Capital Investors believes Australian equities continue to be supported by strong fundamentals, and head of investments and chief economist, Shane Oliver, says investors should maintain a bias towards Australian shares.

In one of his recent market reports, Oliver explained that Australia’s relative underperformance in 2010 was a result of the rising of interest rates (when they were close to zero in other developed countries); concerns internationally about an Australian housing bubble; the strong Aussie dollar that affected internationally exposed companies that did not have a hedge in the form of high commodity prices; and concerns about policy in China.

Earning downgrades in Australia — along with upgrades internationally — reinforce all of Oliver’s concerns.

However, Oliver says he expects to see Australian shares perform on a similar level to global shares, and while it is too early to say whether Australia’s relative underperformance has run its course, it is supported by strong fundamentals.

On a five-year basis, Australia’s higher dividend yields, better growth prospects that the US, Europe and Japan, fewer structural constraints and franking credits for Australian-based investors should result in a bias towards Australian shares over traditional global shares, Oliver says.

Barnes adds that Australian company balances are looking good.

“They haven’t fired staff, they’ve raised capital, the yield is high at the moment and they’re in pretty good shape. Australian equities is still not a bad place to be,” he says.

Barnes says that AMP Capital Investors is looking for a reasonable level of return from the Australian sharemarket this year. “And I think that you’ve got a positive economic backdrop that’s driving that,” he adds.

Howitt agrees that the key fundamentals that have driven Australia’s growth story for a long time will remain in 2011.

“Population growth, natural resources, high dividend yields and growth in dividends, corporate governance — all those fundamental drivers of our economy and our equities will remain in place. The market is not expensive, so from a bottom-up basis for Australia, we think the market is quite attractive.”

Researcher Morningstar does not have any major concerns about the economic outlook for Australia, yet maintains an underweight exposure to Australian equities simply because international equities present much more value in comparison, says co-head of fund research Tim Murphy.

Barnes says the things in Australia’s favour include the resources boom, favourable terms of trade and some massive multi-year projects that are underpinning capital expenditures.

“So those elements alone are providing a very strong macroeconomic backdrop, and we think that will flow through to the equities market and the sort of returns that are coming from that market,” Barnes says.

Pease says while there are great opportunities in resources, he is concerned about the sector.

“We’re seeing that it really is a stock selection market right now. What I would be cautious about for investors is chasing the resources boom too hard,” he says, adding that the rebound in resources and commodities following quantitative easing in the second half of 2010 was worrying.

Barnes agrees that anything could happen over the year, which is why they tended to take a long-term view of companies and what is a sustainable level of growth and demand in the market.

“While there is likely to be some short-term volatility — particularly as China seeks to take a little bit of heat out of the economy — the longer-term outlook for China, India and the emerging world is quite significant growth,” he says. “And that in itself will continue to drive activity in the resources space, and demand for the sort of bulk commodities that Australia has a competitive advantage in.”

Areas of concern

Australia’s dependence on booming emerging markets, especially China, is something that most managers are keeping an eye on.

“The extent to which the Chinese economy slows in response to a number of the measures the Chinese administration is putting in place — increasing the reserve ratio requirement at the banks, potentially putting up interest rates, some administrative measures that they are putting in place — all of those have the potential to slow down both the demand and pricing for commodities,” says Barnes.

“So we’re watching that very closely, looking to understand how the trajectory of Chinese growth unfolds and how that flows through to commodity prices.”

Murphy says a fall in demand for Australian commodities will have a material effect on both the Australian sharemarket and the broader economy, “which is a factor largely out of Australia’s control”.

He adds that while there is a reasonable level of confidence in China’s growth story, inflation in food and property is a concern there.

Howitt agrees that a key concern is regulatory intervention in China, but she adds that regulatory intervention in Australia is also a worry.

“It’s quite interesting that that has emerged as a significant theme over the last couple of years, when up until then you would have placed Australia as one of the best countries to do business with,” she says.

“But we’ve seen intervention or aspirations to intervene from the Government into the mining sector, the telco sector, the banking sector and the retail sector, and now there is a specific levy on personal incomes.

"That’s raised an issue with investors as to just how interventionist this Government might be, and because it’s so broad-based across so many sectors of the economy, I believe it’s led to an increased perception of sovereign risk, which most investors would not have had for Australia before the last couple of years.”

Murphy says that along with decisions by the Reserve Bank of Australia (RBA) to raise interest rates, policy decisions like the flood levy are something that Morningstar is keeping tabs on. He adds that the stability of commodity prices is another concern, given that they are quite high at the moment.

“Given that those issues exist in Australia and don’t really exist to the same magnitude offshore, it’s felt that better opportunities rest offshore at this stage in terms of equity investment,” he says.

Howitt says a major challenge for Australia is the internal balancing required to manage a two-speed economy, including the RBA’s interest rate decisions.

“Continuing to raise rates will do nothing to cool the sectors that are really booming, like mining services and infrastructure, but it will put the brakes on sectors that are already quite subdued,” she says.

She adds that if rates remain high, the dollar will remain high, presenting a risk for non-mining exporters.

Barnes says another concern was how the commercial banks were responding to slower credit growth, which presented challenges for the major banks and how they deal with high funding costs that the Basel III changes propose.

“I think that will pass through,” he says. “But as the changes occur it will be important for us to monitor closely how the banks perform or how their expectations of performance change.”

Pease believes macro-economic factors will continue to affect Australia in 2011.

“The bigger themes that we are seeing are the global ones, particularly the potential for volatility this year,” he says.

“And this is something that is going to affect Australian investors as much as anywhere else in the world.

"Markets by their nature are volatile, but you just get the sense that this year there will be an unusual number of volatility-creating events,” he says, referring to ongoing economic issues in Europe and geopolitical concerns, such as North Korea aggression and protests in the Middle East.

“What are the implications for economic growth, profits growth and interest rates?” Pease asks. “Because they are the fundamental factors that would then impact on asset returns.”

He notes, however, that it is important for investors and fund managers to be careful not to overact to such events, since they could be transitory issues.

The Queensland floods and other natural disasters are not expected to have too much of an effect on Australian equities. Barnes says while the financial impacts of the floods have been devastating, businesses would reopen and begin to rebuild.

“That process of rebuilding and restarting has a strong positive flow-through into the economy. How the Government finances that — whether through a levy or taking on board additional debt — remains to be seen, but they are both valid approaches,” he says.

From a fund manager perspective, Pease says it is amusing to see there is nostalgia for early 2009.

“Because at least back then, amongst all the chaos and panic that was going on, we were pretty confident about two things: everything was cheap, and because of all the stimulus that was being pumped in it was going to turn around at some stage,” he explains.

The problem for fund managers, says Pease, is that as they head into the third year of the share market recovery, nothing is particularly cheap anymore — nor is it expensive.

“It’s just hard to have those high-conviction views that you want to have asset X over asset Y. So we keep coming back to a world where we’re seeing moderate growth in economies, and moderate growth in corporate profitability and where valuations are broadly okay — we have a modest approach to sharemarket exposure in our portfolios,” says Pease.

“It’s a time for staying at your long-term asset allocation — it’s not a time to be saying ‘I want to be completely invested in emerging markets, or equities, or sell all my large cap stocks and buy small caps, or sell everything and buy gold’.

"It’s a market, which from our perspective at Russell, should be a good market for bread and butter type of investing, which is active management.”