Changing down a gear

Australian equities have been the star performers of many portfolios in the past 12 months, and every day the market gets stronger.

But, like all good things, it has to end sometime and many are starting to predict a downturn that will knock a few points off the returns in 2005.

Lower expectations

Invesco head of Australian equities Rohan Walsh says investors have to understand that Australian equities’ strong performance cannot last.

“We have had a couple of years of strong growth and in reality, we cannot expect it to continue,” he says.

“Big dividends, coupled with very strong earnings, have seen upgrades to earnings expectations and, as a result, the market goes up and becomes more expensive.”

K2 Asset Management chief investment officer Mark Newman agrees.

“I think the Australian market has outperformed for the last seven years,” he says. “To say it will continue is difficult.”

Perennial Investment Partners head of Australian equities Adrian Mulcahy also issues a warning: “Last year we saw a year when all companies benefited from an abundance of growth... this year, growth will be harder to come by.”

Economic slowdown

Newman says there are a couple of factors that might mitigate against the Australian market continuing its strong returns.

“There are signs of economic slowdown and a lot of mid-cap companies are reporting disappointing earnings,” he says.

“We have seen analysts downgrading 40 companies so far due to poor earnings.”

Newman says the cost of materials and wages are rising, which could force down earnings and slow the market.

“Combine this with monetary policy pressure being applied a little more tightly and the market will slow,” he says.

Walsh says Invesco is predicting that the domestic economy will moderate this year and this will put pressure on company earnings and investor returns.

“Given the current debt levels and higher price inflation there is a move to caution,” he says.

“Margins are getting squeezed in the construction industry and raw materials prices are increasing, so there is cost creep and that makes it hard to expect earnings to expand.” Walsh says bond yields are also heading up, which is another indicator of decreasing returns from equity markets.

Maple Brown Abbott head of client services Tim Hordern says we are witnessing strong profit growth from Australian companies, especially in the recent reporting period last month. But he adds: “We are starting to see some signs of slowing in areas such as building approvals, and interest rates are on the rise. We think the market is assessing the risk, but it hasn’t yet included that in the pricing of stocks.”

Cyclical trends

Hordern says while many companies are reporting continuing earnings growth, investors will continue to believe that the outlook is positive. As a result, investors do not recognise the risk exposure of future share price movement.

“But we think current results are peak earnings,” he says.

EQT Funds Management chief investment officer Harvey Kalman says investors must heed cyclical swings.

In a typical cycle, companies go through three phases, which takes a few years to run through.

“The first phase of the company cycle is cost-cutting and controlling of expenses. Companies then move onto the second phase, which sees them develop organic growth, but people then start to talk about acquisitions to achieve more growth. Companies will also talk about takeovers at silly prices,” he says.

Kalman says the third phase sees this talk turn into actual acquisitions — usually at silly prices. As a result, companies end up paying far too much for assets.

“After the takeovers, this then leads companies back to the first phase.”

It is not difficult to see the market’s current phase, with Fosters trying to take over Southcorp, smaller Metcash trying to swallow its larger rival Foodland and a potential battle for WMC.

“I am saying it is time to diversify,” says Kalman. “There is a lot of cash waiting to go into the market as a lot of people are saying they have made money out of the market. But remember what happened in 2000-02 when a lot of people ended up poor [after the tech boom].”

Predictions for 2005

However, there are differing views as to the actual pattern of growth and how any subsequent slowdown for the Australian market will pan out.

One possible scenario is comparable to 1987 where the market continued to report strong growth before something triggered a massive correction.

But Walsh says that scenario is not part of the Invesco model.

“Our policy is based around market levels not looking for major change this year,” he says.

“The key is for the Reserve Bank of Australia to talk aggressively to keep people’s expectations moderate. There is some unwinding of the cycle at present with inflation going up, but energy prices stabilising.”

However, there is another risk for the Australian economy. The demand for natural resources will benefit some states, while a slowdown in consumer demand will hit the traditional manufacturing states.

“There is a risk that Western Australia and Queensland will become stronger with the growing demand for natural resources, while New South Wales and Victoria experience problems associated with interest rate rises,” Walsh says.

Newman says while there are predictions of gloom ahead, K2 doesn’t think the outlook is very negative.

“Resource stocks are doing very well and, as prices for commodities rise, that sector does very well,” he says.

“But there are some bottlenecks in the infrastructure around the resources sector that need more thought.”

Fund selection

Australian equities will still be showing positive returns this year but not at 2004 levels, Newman warns.

“If the Australia market gets 10 to 15 per cent growth, it will still be a good result,” he says.

Kalman says investors in this market should be looking for fund managers that get downside protection from the market in their funds.

“Look for a fund manager that has a short/long bias in their fund,” he says.

Hordern adds: “We think some sectors are over-valued, especially small to mid caps, which have had a very strong run.”

If some sectors come under pressure, investors can switch to defensive stocks to protect their returns — and the banks are always a favoured haven.

“Conditions are good for banks with strong credit growth,” Hordern says.

“But we are starting to see consumer spending at high levels and debt rising, combined with a slowing residential market. That could put pressure on the banks.”

Mulcahy says investors will have to be careful.

“We will be looking at companies that have exposure to offshore and mining stocks with exposure to China’s growth,” he says.

Walsh says some sectors of the Australian market will expand this year and some will face cyclical downturns.

“Construction and materials are expected to be downgraded,” he says.

Investment cycles have always been part of investing. Traditionally there have been boom/bust cycles, but Walsh argues the days of volatile markets might be over.

“The back of inflation has been broken and we are better at managing the cycle,” he says.

“People are investing in markets that are safer and everybody has gone through the defensive phase, which was always part of the cycle.”

However, one thing is certain, Australian equity markets this year are going to be an interesting ride — one that will have to be taken with caution.