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Australian profits, growth, interest rates and shares

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The December half profit reporting season was far better than feared and big cost controls have helped lay the ground work for stronger profit growth ahead.

While interest rates may need to fall a bit further, green shoots of recovery suggest we are at or near the low and more importantly point to an improvement in economic and profit growth on a 12 month horizon.

While the share market has moved up ahead of profits this is not particularly unusual and price to earnings multiples are just around their long run average.

Introduction

Since Euro-crisis lows in late 2011 the Australian share market has rallied 32 per cent, reaching its highest level since the GFC. However, the share market has run well ahead of profits and there is still much debate as to how the economy will traverse the slowdown in mining investment and whether interest rates need to fall further. This note looks at the key issues, starting with the profit reporting season just passed.

Profits down but cycle looks to be bottoming

While the December half profit reporting season saw a fall in overall profits of around 9 per cent on the December half a year ago thanks to a roughly 35 per cent slump in resources profits, the outcome was far better than feared and there’s some light at the end of the tunnel. The key themes were as follows:

  • First, results were much better than feared with 44 per cent of companies exceeding market expectations, which is the best in three years. Consistent with this 55 per cent of companies saw their share price outperform the market on the day their results were released highlighted by good jumps in cyclical value stocks like Harvey Norman, JB HiFi, Qantas and Bluescope Steel.


Source: AMP Capital

  • Sales growth was weak at around 1 per cent, but there was an aggressive focus on cost control and productivity gains to manage margins, which is a normal precursor to a decent rebound in profits and a sign Australian companies may be starting to catch up with their American counterparts in focussing more on productivity..
  • Outlook comments appear to be improving, with a rising trend in the net balance of positive relative to negative outlook statements as evident in the next chart.


Source: AMP Capital

  • The improvement in the outlook is backed up by rising dividends. 53 per cent of companies increased their dividends from a year ago and only 22 per cent have cut them. 40 per cent exceeded expectations on dividends with only 26 per cent disappointing. Rising dividends suggest companies are confident that there will be an upturn in the profit cycle.

Reflecting this, analyst earnings estimates have been upgraded slightly for the first time in two years. Resource profits should bounce back a bit this year reflecting in particular a rebound in iron ore prices after last year’s fall. Profits for industrials (ex banks) bottomed in 2011 and grew around 12 per cent over the year to the December half helped by cost controls and a modest pick up revenue.


Source: UBS, Deutsche Bank, AMP Capital

The key going forward will be what happens to the economy.

Growth still a risk but some positive signs

Australian GDP growth clearly slowed through the course of last year. In fact growth has been stuck around an annualised 2.5 per cent pace for the last three quarters as the pace of investment has slowed and consumer spending softened.

First the negatives. The biggest uncertainty relates to the slowdown in mining investment at a time of weak non-mining investment. On this front the recent capital expenditure survey from the ABS presents a confusing outlook. A conventional interpretation of initial investment intentions from Australian businesses for the next financial year, by adjusting them for the average gap between actual and expected investment (the “realisation ratio”), points to solid investment growth of around 14 per cent in total. However, realisation ratios vary dramatically from year to year and can be very weak in times of uncertainty. A contrary interpretation can be obtained by comparing the initial estimate of investment for the next financial year to the corresponding estimate a year earlier, and it fell for the first time in four years. This is only the sixth time in the last 25 years that this has occurred and when it occurred in the past it has often coincided with a fall in actual investment. See the chart below. At the very least it suggests a sharp slowing in business investment growth,


Source: ABS, AMP Capital

More broadly the response to interest rate cuts has been sub par, with most economic indicators – retail sales, building approvals, confidence measures, credit growth, house prices – taking longer to pick up than has been the case through past easing cycles. This reflects a combination of factors including post GFC caution, the failure of the Australian dollar to fall, the limited pass through of rate cuts by banks, fiscal tightening and a perverse dampening effect on non-mining sectors from the mining boom, many of which were told repeatedly that they just had to adjust.

However, green shoots are gradually starting to appear, suggesting rate cuts are getting traction.

  • Consumer and business confidence readings are up from their lows. Consumer confidence is in fact now at around the average level it has reached this far into the past three rate cutting cycles. The reason rate cuts help household spending is simple. Firstly, total household debt at $1.7 trillion far exceeds the value of deposits at $0.75 trillion. So the benefit of rate cuts to borrowers far outweighs the loss to depositors. Secondly, the spending of depositors such as self funded retirees tends to be far less sensitive to changes in their disposable cash flows than borrowers, particularly young families. 
  • Reflecting this, retail sales had a good start to the year.
  • Home sales, auction clearance rates, house prices and to a lesser degree housing finance suggest that a gradual housing recovery is getting underway which should boost housing construction activity.
  • Investors are starting to look beyond falling term deposits at higher yielding investments such as corporate debt and shares which is part of the process by which monetary easing forces more risk taking and spreads the availability of capital throughout the economy.

The $A, whilst still strong, is at least off its highs.

To ensure that these still fragile green shoots flourish there is a case for the RBA to cut rates a bit more to push borrowing costs down to the lows seen at the end of past easing cycles in 2002 and in 2009. Eg, the major banks’ standard variable mortgage rates are still around 6.4 per cent compared to past lows of around 6 per cent. However, this could be achieved if the recent improvement in bank funding conditions motivates the banks to cut mortgage rates independently.

However, while the next six months or so may still see sub-par growth around 2.5 per cent as the economy transits from strong mining investment to more balanced growth, signs of an improvement are gradually appearing. This in turn augurs reasonably well for a pick up in profit growth over the year ahead as profit growth for industrials remains around 10 per cent, banks and wealth managers pick up on a slight improvement in credit growth and increased investor activity and resources sector profits return to modest positive growth

The other point of course, is that while there may still be one or two more rate cuts in the short term, we are nearing the end of the interest rate easing cycle. It’s time for home borrowers to think about taking advantage of sub 5 per cent fixed rate mortgage deals on offer.

Outlook for Australian shares

To be sure the local share market has run ahead of profits, with all of the recent gains being driven by an increase in price to earnings multiples. But as can be seen in the next chart, this is not uncommon as the share market often moves ahead of a pick up in earnings. 


Source; Bloomberg, AMP Capital

However, the forward price to earnings multiple for Australian shares has only increased to around its long term average.


Source: Bloomberg, AMP Capital

Moreover, while there will be a few bumps along the way with a high risk of a short term correction, with earnings growth set to improve this should underpin further gains in the local share market over the year ahead. Our year end target for the ASX 200 is 5250.

Published: Thursday, March 07, 2013

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