Is there trouble ahead for domestic equities?

Domestic equities have performed well in the past and represent a solid option for investors but, as Damon Taylor reports, there are many variables to watch out for.

This time last year Australian domestic equities seemed set to surge on the back of a strong Australian economy and a recession avoided.

Fast forward to present day and there has been little to alter this rosy view but, according to AMP Capital head of Australian equities Greg Barnes, local market gains have been gradual rather than groundbreaking.

"Certainly, last year the Australian economy had a very shallow slowdown compared to the rest of the world where you had a very deep recession driven by the global financial crisis," Barnes said.

"Australia has come out of that shallow slowdown with a fairly slow trajectory of growth - but growth nonetheless.

"You compare that to the US which has come out of the recession with a much more rapid pace of recovery and what we're seeing is that trajectory reflected in the share price performance and a lot of the strong macro economic numbers that are coming out of the US.

"So if you roll the clock forward to this year, I think that the Australian economy is in sound shape," Barnes continued.

"You've got a very strong growth impetus coming from the resources sector, from the terms of trade, and a very strong capital expenditure pipeline, a large chunk of which is related to the resource spending but some of which is related to broader infrastructure spending as well."

Barnes added that when strong terms of trade and high capital expenditure came together, the result was strong nominal economic growth that would also benefit Government revenue.

"You've also got unemployment heading to low levels - notwithstanding the employment figures that we've seen recently - and with employment at fairly full levels you've got a household sector that is in reasonable shape as well," he said. "So with those key growth drivers as a backdrop, the Australian market is in good shape."

Ploughing forward

Identifying global impacts on the Australian equities market outlook, Fidelity head of Australian equities Paul Taylor agreed that there had indeed been steady growth but added that it had not been without its headwinds.

"If you looked over the last 12 months, there's really been a bit of a 'sawtooth' happening," he said. "We've been up and down but we've really gone nowhere.

"So I'd characterise it by a solid Australian economy, great companies, good balance sheets, all the micro things you're looking for but we've also had these black clouds hanging over us from a macro perspective," Taylor continued.

"So the sovereign debt crisis in Europe which seems to be working its way through the European economy from Greece to Ireland to now Portugal and potentially Spain, then there's the Middle East's geopolitical issues and that's obviously kicked off some more macro.

"So for the last 12 months, we'd have the market move based on these sort of micro fundamentals, which all look positive, but then we get knocked back based on these macro issues."

Not seeing the same black clouds internationally, Barnes said there was much in global markets that would support local market growth, rather that detract from it.

"The Australian backdrop is sound but you've got a broader international economic environment which is quite robust as well," he said.

"You've got that strong growth impetus coming though in the US - obviously Europe is a little bit behind that, but core Europe is doing okay - and then you've got the emerging markets which are really the key engine of growth globally.

"So as we roll through 2011, I think we've got an environment which is going to be quite supportive of equities," Barnes continued.

"Typically, that third year coming out of an economic slowdown is quite a strong year where the second is normally slower.

"So this year, if the pattern is similar to what we've seen in years past, we think domestic equities will have a reasonably firm 12 months."

US outperformance

Yet irrespective of whether activity internationally is likely to have a positive or negative effect on local markets, it is interesting to note that Australia equities actually underperformed the US equity market in 2010.

However for Taylor, despite Australia's stronger foundation at the beginning of the year, such a result was far from surprising.

Pointing out the recent strength of the Australian dollar, he said that although the US economy had come back well, its outperformance was a lot less significant when viewed in terms of a constant currency.

"The US did perform quite strongly but for them the recession and difficult period was much worse, so the recovery was always going to be a little bit stronger," said Taylor. "But the big factor that moved in Australia was the dollar.

"Often if you put these things on a constant currency basis, it tends to even things out significantly," he continued.

"But the US was obviously a weakening currency so, from an Australian investor's perspective, the difference was probably a lot smaller because while you had an improving US market, you would have lost money on the currency.

"When you're trying to compare globally, you need to put everything into a constant currency."

Equally unsurprised, Barnes said that the slowdown in the US was probably unprecedented in many ways.

"Confidence was really shattered," he said.

"They had a housing sector which was in pretty significant difficulty and it really took the various stimulus measures a while to get traction.

"Now, however, we're seeing those stimulus measures gaining momentum and as a result the economy is on quite a sharp growth recovery," Barnes continued.

"Australia, on the other hand, was a much shallower slowdown and not even a recession as it turned out.

"And what happens is that from an equity market perspective, analysts put through an earnings revision - so the actual earnings numbers that companies report typically surprise as well."

According to Barnes, several strong reporting seasons with strong earnings upgrade cycles for US corporates meant the US equity markets were always going to be well placed for significant growth.

"On the other hand, if we look at the most recent Australian reporting season, if anything we've probably had some slight downgrades to earnings growth expectations," he said.

"So if you compare the two markets and the two outcomes, that probably explains a great deal of the weaker performance that we've seen here in the Aussie market."

Along similar lines, Vanguard Australia and Asia Pacific chief investment officer Joe Brennan said markets that are more severely depressed would always bounce back further.

"A lot of the headlines and prognosticators like to talk about the economic numbers and other things like that," he said.

"But the biggest driver in any period usually ends up being the market and, more importantly, what they're willing to pay for a dollar of growth - in other words, the valuation.

"So the valuations were so depressed in the US, much more than here, that what you got was the valuations coming back a lot," Brennan continued.

"It wasn't that the US companies were performing all that much better or that the economy was anywhere close to as good a shape.

"That's not what the market was saying. What happened was a bounce off the bottom of valuation land."

Steady hand on the tiller

Bringing the focus back to local equity markets, Barnes said that while performance has been steadily positive through 2010 and the beginning of 2011, the reality is that there will always be developments on equity managers' radars.

"So one of the main ones we'll be watching carefully, despite its recent strength, is the resources sector and how it impacts the rest of the economy," he said.

"Because the flipside of a very strong resources sector is that the Australian economy needs to make room for that exceptional growth.

"By that I mean that the Australian economy just doesn't have the capacity to accommodate the sort of growth that we're seeing in the resources sector and therefore some of the other non-resource sectors in the economy need to make a little room, to give up a little bit of capacity, to do that," Barnes continued.

"It's really that sort of non-resource related sector that's been fairly slow to recover even though there have been expectations that it would and a lot of the macro data is suggesting that it should be picking up."

Barnes said that the banking sector was another area of focus for AMP Capital.

"The banking sector's gone through a period of significant change with the adjustments to their capital bases, the higher cost of capital, the housing market slowdown," he said.

"So banks have gone through a period of adjustment to prepare themselves for what looks like will be a slower credit growth environment.

"And certainly last year I think that was weighing on the bank sector," Barnes added. "This year it looks like some of those pressures have eased and the bank share prices have come back.

"So it's an analysis about whether the bank sector looks reasonable from a share price perspective compared to the current outlook that they face."

For Taylor, the other domestic fear on peoples' radars was interest rates.

"So if you look at it from an average Australian's perspective, the things probably on their mind are interest rates and where they're going," he said.

"They're probably thinking about the carbon tax, is that going to have any impact on prices, are electricity prices going to go up, are petrol prices likely to do the same?

"Now, increasingly, the words coming from the Reserve Bank seem to be that interest rate rises are getting pushed out further and further," continued Taylor.

"Consumer confidence is reasonable, they see Australia's in a good position but I think people generally have been trying to get their finances in order.

"So that's potentially been holding back the domestic economy but I think the Reserve Bank is definitely feeling that they've done their job with the interest rate rises we had in succession last year."

Inflation fears

Echoing Taylor, Brennan said that inflation was the one blip on the domestic equities radar that could compromise Australia's current growth.

"I think the strong growth that's in place in Australia, there doesn't seem to be a lot of things tipping it over," Brennan said.

"The one thing that you'd want to keep an eye on - and I think the RBA is fully aware of this - is the fact that inflation isn't necessarily a global phenomenon. It can be a regional or local phenomenon.

"And in so far as the Australian economy is, when you think about some of the drivers of its success being the commodities boom, metals and mining, jobs, currency and all of this surging activity, there are a lot of linkages to a single factor," Brennan continued.

"But I think the RBA is acutely aware of that and they have their finger on the trigger to raise rates and stem off any inflation."

But despite a number of both domestic and global issues that Australian equity managers will be keeping a watchful eye on, the bottom line seems to be that domestic equities are well placed for a year of growth in 2011.

Brennan's prediction was that the next 12 months would be a continuation of themes for the local market.

"It seems to me that a lot of the same things will continue to be in place," he said.

"The global economy is healing, demand for resources is set to continue and Australia's fundamentals still seem to be intact," Brennan said.

"So while I'm not good enough to tell you whether or not that's going to continue, it seems for right now as though a lot of the drivers for growth are still in place."

For his part, Barnes said that there was every reason to be upbeat about equities.

"We've been looking for a mid-teen return at a capital level when the market's on a 4 per cent yield," he said.

"I think our strategist Shane Oliver is on record as calling the market up around the 5500 level, and obviously this pullback gives us some pause for thought around that but certainly that's the target level that we've been looking at.

"I think if you step back and look at things certainly over the last 20 or 30 years, the Aussie market has outperformed internationally," continued Barnes.

"We've got a strong demographic growth profile which underpins economic growth here and that has a strong correlation with market performance and we don't see anything to really change that."

Barnes said that if one looked back over the longer term, Australia had done very well over a century of market returns.

"In fact, we've done extremely in terms of the real return from equities in Australia," he said. "It's been among the best globally."

"There is a very sound capital market here and a very sound equity market. There's no reason to think that sort of performance won't continue."