Australia's stock market is heading for a dividend cliff

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Soft domestic demand, falling terms of trade, a souring earnings cycle and the resurfacing of two-way risk in global bond yields is threatening to take the shine off Australia’s stock market.

That’s the view offered by Konstantinos Venetis of Lombard Street Research who, in a note released earlier today, believes there’s a looming dividend cliff about to hit Australian financials and materials firms, the two largest sectors on the ASX 200.

Here’s Venetis on what has helped underpin the index in recent years, and why he’s pessimistic on the outlook for Australian stocks.

“Despite the deceleration in earnings, dividend payout ratios have surged from 55% to well over 70% in the last four years. High dividend yields have been instrumental in helping the bank-heavy (ca. 50% weight) ASX200 benchmark index shrug off the end of the commodity supercycle. However, this tailwind is weakening. The stock market has been on the back foot since April, when the major banks announced smaller-than-expected interim dividends.

A confluence of headwinds is facing Australian banks, which have now switched to capital-raising mode.

In contrast, the big mining companies – dominated by BHP and Rio Tinto – have stuck to their ‘progressive dividend policy’ of at least maintaining the US$ dollar value of their payouts. But with profits contracting, they have increasingly funded these dividends by cutting costs, disposing of non-core assets, tapping debt markets and severely reducing investment. In this regard, lower oil prices have added fuel to this ‘carry trade’ by rendering incremental production cheaper. However, such a strategy should eventually run up against its limits, especially if volumes of iron ore exports to China catch up with the decline in prices”.

The chart below, revealing the trend in earnings growth for both financials and materials, is clearly lower.

Venetis believes investors seeking high-yielding investments, having supported financial and resource stocks in recent years, will move towards Australia’s real estate market, partially in response to the recently signed free trade agreement signed between Australia and China.

The ASX 200, despite its recent falls, is currently up 5.05% year-to-date.

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