Bond yields and China: the market's trump card?
Despite the various risk factors faced by the Australian equity market last year, it’s perhaps remarkable that it managed to produce a fairly decent outcome. In analysing the reasons, we can really focus on two factors: bond yields and China. Barring a spanner in the works from Donald Trump, the good news is that these factors may continue to keep the market ticking over fairly nicely this year also.
The Australian equity market’s total return in 2016 was close to 12% - which is little above the broadly 10% return we might expect from the market over the long-run. Of this, the usually reliable grossed-up dividend return was around 5%. Stock prices provided the extra 7% return, the contribution to which were broadly split between higher (forward) earnings and a modest rise in the market’s price to forward earnings ratio.
Indeed, one of the surprises of 2016 was that the market’s elevated PE ratio managed to stay elevated – in fact it rose a little further, from 15.6 to 16.1, compared to a long-run average closer to 13.5. The lesson, however, was that super-low bond yields continued to justify a higher than average PE ratio. Indeed, local 10-year government bond yields actually eased back a little last year to end at 2.77%, which by my estimates had the equity market on a “fair-value” PE valuation given long-run bond-equity relationships. So those, myself included, that continued to fret about a “regression to the mean” in PE valuations did not have their fears validated by the market.
The other big story in 2016 was the resources sector, which defiantly rose from the ashes in the face of considerable investor scepticism. But this was not all hot air. As it turned out, China’s decision to support wavering growth by relaxing constraints on home building and unleash even more infrastructure projects actually saw its steel demand strengthen last year, following what appeared to be the start of steady annual falls in 2015. Add to that cuts in China's own iron ore and coal capacity, and the stage was set for a lift in its resource imports which led to surging commodity prices. Weather related supply setbacks in both Brazil and Australia added to the upside in prices.
The result of all this was a stunning 50% rebound in resource sector forward earnings over the year, which led to a modest 5% gain in overall market earnings despite continued sluggish performance in the non-mining sectors. Indeed, last year resources were a classic cyclical play – a good time to buy was when the sector’s PE ratio was elevated, in anticipation of a rebound in depressed earnings, which in fact, was more stunning than most anticipated. In turn, this has allow PE valuations in the sector to fall to more reasonably (though still a touch pricey) levels in recent months.
Where to from here? While I’m increasingly nervous about Donald Trump, I suspect his more erratic ways will be eventually kept in check by those around him. As for the economy, the key take-way from his plethora of executive orders last week was that he’s clearly decisive – and keen to live up to his promises – which bodes well for his pledge to slash taxes and boost infrastructure spending when he eventually focuses on this.
Closer to home, while US bonds yields are likely to rise further this year, ours will likely rise by somewhat less – especially if the RBA cuts rates again as seems possible given persistently sub-2% underlying inflation. That, in turn, could keep the market’s PE ratio relatively elevated at around 15-16 times forward earnings.
Meanwhile, provided coal and iron ore prices don’t slump too far – which is a reasonable bet given China’s pledge to support growth and further rationalise its own resources industry – then further earnings upgrades could flow through in the resources sector. Indeed, even allowing for the natural tendency of bottom-up equity analysts to be overly optimistic on earnings expectations, I still see scope a further moderate 5% gain in overall market forward earnings this year, led by our miners. If the RBA cuts rates and the $A falls further, an overdue improvement in non-mining earnings could also emerge.
So Trump aside, key positives for the local market this year are the RBA’s lingering easing bias and China’s determination to keep its economy ticking over.
Published: Wednesday, February 01, 2017
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