The Australian economy is facing serious challenges as the resource sector boom unwinds.
Resource capex and commodity prices are falling, and real income growth is very weak. However, according to Tim Baker and Joseph Kim, equity strategists at Deutsche Bank, these are well-known stories, having been established up to three years ago.
While others continue to focus on the negatives, Baker and Kim believe that there is a distinct improvement under way across Australia’s non-mining sectors, something that makes them upbeat on not only corporate earnings but also the outlook for the economy.
Noting that monetary policy settings that are at their loosest since 2009, the pair point to a stabilisation in the unemployment rate and non-resource growth accelerating at the fastest pace in three years as evidence of improvement in the economy.
Given the perceived improvement, Baker and Kim offer three reasons why they believe the outlook for the economy, and as a consequence corporate earnings, is positive.
- Housing starts aren’t high relative to population, and construction as a share of GDP is barely above average, well short of past peaks. Further, companies are seeing selling price upside which should continue.
- Companies reported solid consumer spending growth during results, despite fears that weak wage growth would weigh. There are early signs of better wages (bonus growth is up). In the meantime, households can still draw on elevated savings, and continue to benefit from record low inflation in essential items.
- We’re skeptical of the capex survey saying non-resource businesses will cut capex. Other indicators are positive: profit growth has reached a 4yr high, and we’re seeing more hiring, borrowing & vehicle purchases.
Along with previous monetary policy easing from the RBA between 2010 to 2013, something that they believe contributed to the improvement across non-mining sectors of the economy in recent quarters, further rate cuts from the RBA in early 2015 “should ensure a healthy amount of stimulus flows into 2016”, in their opinion.
Given the recent improvement in Australian business surveys – all three industry-specific PMI reports recorded an expansion in August while business conditions jumped to a six-year high in trend terms in today’s NAB business confidence survey – they suggest that the outlook for corporate profits doesn’t look too bad, particularly outside of the resources sectors.
Baker and Kim point to the Deutsche Bank ‘profit pulse indicator’, a timely aggregation of Australian macro data, which has been holding up well of late. It currently sits in positive territory, something that points to modest corporate earnings growth.
While earnings revision momentum for the market is below average and has been trending down, as shown in the chart above, they believe the story for cyclical industrials and small industrials is significantly better.
“Given these segments of the market are more linked to the economic cycle, they provide reason to stay relatively upbeat”, they state.
So what sectors do Baker and Kim favour to take advantage of the cyclical upswing?
“The solid macro backdrop should be good for banks – combined with low rates and gearing, our model points to no rise in bad debts. Credit growth is decent (6%), with further upside for business likely. Capital ratios have already come a long way, and banks are 10% cheap on a PE relative basis (trading at ~12x). Resources still look challenged, and aren’t cheap (~15x, even with EPS downgrades potentially coming). China’s nominal GDP growth remains low, while producer prices & exports continue to fall. Our economists expect better growth on the back of recent stimulus, but this may not be enough to help commodities, given supply is still strong. Energy looks more interesting, but is likely to require strong demand in the northern winter (we cut to underweight).
We continue to back cost-out stories (QBE, MPL, AGL, AMP), but note that revenue growth is edging higher. Offshore plays look pricey, but we like stocks delivering good growth regardless of AUD moves (JHX, ALL, CSL, SHL). Yield is likely to remain a key part of stock returns, but we can find it in stocks that offer some EPS growth as well, rather than traditional yield plays”.
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