Selected gains to be made...

Australian equities look set for another positive 12 months and a possible global re-rating after beating back last year’s regional slowdown, writes investment analyst Michael Coop. But he also warns that, as in 1998, this year’s predicted gains will be confined to a few market sectors.

Despite a year of high volatility and a number of external shocks, the Australian share-market showed resilience last year. Against a backdrop of continued low inflation, the All Ordinaries Index rose around 7.5 per cent in capital terms for a total return of around 11 per cent.

A few sectors dominated the overall performance of the Australian market last year, in particular domestic service-oriented companies and non-cyclicals. Telecommunication companies rose 45 per cent on the year, alcohol and tobacco 40 per cent and developers and contractors 25 per cent.

The worst performers, on the other hand, were cyclical and commodity sectors. Energy fell 37.7 per cent and engineering 23 per cent.

In 1999 we remain optimistic on Australian equities in the medium term. Share valuations are reasonable and potential earnings growth is strong, while demand and supply for shares is favourably balanced. Future corporate earnings are likely to be supported by lower local interest rates - which should stimulate domestic growth - and cost-cutting measures at the corporate level.

However, the market still remains highly volatile and a correction would not surprise after the strong rally from the lows reached in September.

The Australian market in a global context

There are forces in the Australian share-market which we believe provide scope for a global re-rating of Australian equities.

The Australian share-market has changed radically as a result of privatisations and demutualisations. Now a much larger part of the market comprises growth companies and sectors - telecommunications and financial services are examples - rather than cyclical, basic industries where the value added is relatively low.

As a result, earnings outlooks have improved while earnings profiles are less volatile.

This is a positive and relatively new factor for the Australian share-market which hasn't yet been fully digested by global investors, many of whom still regard our market as a commodity play. But since the Asian crisis they have started to rethink Australia.

The share-market is also supported by a positive demand/supply balance. Despite the $14 billion extra issuance from Telstra, compulsory superannuation contributions, public sector budget surpluses and share buy-backs have improved net demand for shares. In addition, local institutional investors have relatively high cash weightings in their balanced funds.

Compared to the US, our earnings forecasts are reasonably realistic, with lower valuations and earnings risk. There is actually an upside risk in Australia, since stronger-than-expected profits could emerge from a stronger-than-expected economy. While the Australian market doesn't have the dominant and sexy sectors of the US market, such as technology and pharmaceuticals, its defensive qualities are nevertheless attractive.

On a relative valuation basis, we believe Europe remains more attractive than Australia due to ongoing interest rate cuts and rationalisations, which continue to underpin a strong market. Not surprisingly, we rate Australia as more stable than Asian markets.

The sectoral framework

The key pillar of the local share-market, Australia's banks, have performed well relative to the major global banks that were exposed to third-world debt and higher-risk domestic lending. Provisioning still looks healthy and there's no sign of a bubble in land or asset prices, which underpin bank loans. Growth is supported by consumer borrowing and increases in fee income. The impact of the GST and Y2K are the biggest sources of uncertainty ahead, while the extent of consumer debt should be monitored closely.

Our macro view on resources is that commodity prices will likely bottom sometime in the second half of 1999 and it will be some time before these companies return to favour. We are therefore maintaining an underweight resources position in the deflationary global environment until cutbacks by producers or a pick-up in global manufacturing activity become evident.

Australian cyclicals are still languishing, and we believe their future depends on whether companies can compete and position themselves correctly rather than just play the cycle.

However, it's difficult to see cyclical stocks improving markedly without a substantial pick-up in world growth.

Consumer defensives, including alcohol, tobacco and retail, look relatively positive.

While the market provides few opportunities for pricing power, listed retailers are claiming market share from unlisted companies - an important trend evident in stocks such as Harvey Norman. Some are also exploiting specialisation at the expense of department stores.

The big issue for this sector in 1999 will likely be the GST's impact on consumer spending. However, our forecasts are still positive for consumer stocks due to employment and income growth and sustained low mortgage costs. We are also confident about growth in the telecommunications sector.

Investing in Australia

Our Australian equity investments are biased towards companies with dominant franchises, quality management and strong growth prospects.

Of our key holdings, Westfield Holdings remains positive, with US expansion plans providing a good avenue to strong earnings growth over the coming years. Harvey Norman continues to cut ribbons on new stores and gain market share. Qantas is proving resilient to the Asian downturn, with long-haul flights offsetting lower regional demand.

And Pacific Dunlop's efforts to better manage costs and remove low returning assets from its balance sheet are beginning to bear fruit.

Michael Coop is Australian equities strategist, BT Funds Management