With the seemingly never-ending European sovereign debt crisis still generating gloomy headlines, the Fed’s “QE2” quantitative easing program desperately trying to stimulate some private demand in the US economy and China worried about quieting rampant asset and price inflation, it’s easy for investors to be worried heading into 2011.
But if investors look at what is front of them – a market trading on 13 times earnings (still well below the long-term average of about 14.8 times) and an average dividend yield is 4 per cent – there are opportunities.
Add this to the fact that at levels near parity, the A$ has opened up for Australian investors the chance to buy global assets without any currency penalty, virtually assured of a currency gain on top of the asset gain as the A$ corrects over the medium-term, and 2011 arguably holds as many opportunities as fears for Australian investors.
“That’s the really big opportunity, to take an over-valued A$ and do something with it,” says Mike Hawkins, head of private clients at Evans & Partners.
“It’s a once-in-a-generation opportunity to get as much money as you can into overseas assets, ideally blue-chip global industrial companies. For an Australian-based investor, you’ve probably got enough resource stocks and banks in your portfolio, so you could ignore them: what you would be looking to do would be to use the currency strength to lock in exposures in sectors that you don’t have in Australia, such as the big global technology, pharmaceutical and food stocks.
“The double-whammy of asset gain and currency gain that you can expect from here is a once-in-a-generation opportunity. You’ve never been wealthier in terms of what you can buy with the A$ overseas. Asset prices overseas are depressed, and if you looked back in five or ten years’ time, and you hadn’t done it, you’d be kicking yourself. It’s not an issue whether the currency goes to $1.05 or $1.10, you just do it,” says Hawkins.
The likelihood of the A$ correcting is one of the “clearest risks” for Australian investors in 2011, says Damien Boey, equity strategist at Credit Suisse Australia. “On any metric that you look at the currency now, valuations are quite stretched. We think the currency is about 20 per cent over-valued at the moment, relative to its fundamentals.
“The only issue is that things can be very expensive, but you need a catalyst for the bubble to pop. Right now, as we head into the first part of 2011, we don’t really see a catalyst. One of the things on the risk side we’re closely monitoring, and again it’s related to the A$ correcting, is Chinese tightening. Chinese tightening can actually be a catalyst for the A$ to fall. What we’re seeing in China now is that they do want to bring their house price and CPI inflation under control, because both, particularly CPI, are really starting to get up there.”
Boey says money market pricing implies that the Chinese authorities will look to tighten by 1 per cent over the next year. “If the money market is right and we do see definitive tightening by the Chinese – and if they are actually going to revalue their currency in more serious steps – then I would start to get worried about China. And when you worry about China’s growth rate coming off, you would start to be worried about the A$ falling.”
This would definitely benefit investors with US$ exposures, he says. “That is certainly an opportunity. We don’t think it’s time to be buying US$ exposures with your ears pinned back yet, but we do also think investors should be looking out for opportunities that are emerging, whether in some of the big global US equities, or in exchange-traded funds (ETFs).”
Conversely, however, Boey sees several sectors struggling if and when the A$ falls. “China tightening and the A$ falling would definitely push Australian shares lower, led by the resources sector. If China were to over-cook its own economy, one of the issues you’ll see is that commodity prices will fall: and house prices in Australia are quite highly correlated with commodity prices, so house prices would also fall.
“Very clearly, there are some big risks to discretionary retail stocks, because the $A falling is bad for their margins, and also house prices falling is bad for retail sales. We’re actually quite bearish on the retail sector. On resources, we’re neutral with a view to even shorting it if the valuations get even more extreme and we see even more overheating in China,” says Boey.
A potential offsetting factor, he says, is that China over-tightening would see the RBA cut interest rates “quite aggressively.” “That would be a bit of a game-changer for quite a few sectors. For example, the banks are going to come under a bit of pressure in the short term as the tightening cycle takes off, but as soon as the easing cycle kicks in, you might actually see them being the first to benefit.”
Shane Oliver, head of investment strategy and chief economist at AMP Capital Investors, says the biggest risk for investors in 2011 is combination of both interest rates and the A$ going too high. “That would be a big dampener on our sharemarket. The big risk this year turned out to be a renewed bout of worries about the global recovery, how that impacted Australia, and of course the high A$ has been a bit of a drag on the market. From here, I think the biggest risk for us is a combination of China tightening too much, Australia tightening too much, the dollar surging and the combination causing a hard landing in our sharemarket and/or property market.”
The biggest opportunity, he says, is a continued bet on the global recovery. “Everyone has got so worried about a double-dip globally, and then suddenly the data has come in on the positive side. We’ll probably see fairly good returns next year out of markets, probably concentrated in the emerging world, but I think Australian shares should do reasonably well in that context. We’re looking for 15 per cent capital growth, and when you add in 4 per cent for dividends, you get about 19 per cent or so total return for calendar 2011.”
Oliver says Australian share valuations are “still OK.” “The forward P/E is about 12.8 times compared to a long-term average of about 14 times. Form a valuation point of view the sharemarket looks OK. My base case would be for reasonable gains over the next 12 months, because valuations are OK, profit estimates have been revised down, but there is still profit growth ahead, and the likelihood is that we’ll see further gains in commodity prices as the liquidity surge from QE2 continues to flow through and boost growth in emerging countries like China and the flow-on effect to commodity prices,” he says.
George Boubouras, head of investment strategy and consulting at UBS Wealth Management, sees the major risks in 2011 as “currency wars” and continued aftershocks from the sovereign risk crisis. “I think if we got heightened currency intervention by central banks, it would probably cause risk aversion to spike. The Australian currency and market would be impacted by that, and so would the ‘carry trade’. People would buy US$, ¥ and Swiss franc as a protection measure. It’s not a high risk, but it’s certainly there.
“As far as sovereign debt is concerned, I think the issue virtually has to resurface very six months, simply because of the maturity profiles. The problem countries – Greece excepted, because it’s now protected for three years – simply have such short-duration debt obligations. So you’ve got Ireland, Spain and Portugal having to roll over debt so frequently, they have to access the debt markets at regular intervals. The ‘bond vigilantes’ can have a lot of influence because of that. We’re not going to see sovereign risk put to bed anytime soon.”
Boubouras says Australian investors also have to face the fact that regulatory risk has greatly increased. “Nearly 60 per cent of the Australian equity market is now under some form of direct political pressure. With the MRRT replacing the RSPT, that’s 27 per cent of a 35 per cent sector – resources – that’s affected; the banking sector is obviously being lined up; the healthcare sector has been since 2007; telcos (for obvious reasons) are under regulatory pressure; it’s the same for utilities, particularly from state governments; and you’ve also got the gaming sector.
“When you add it all up, nearly two-thirds of our market is impacted by regulatory and/or government risk. Investors are used to having fiscal and monetary policy hanging over their heads: I think ‘regulatory’ is now the new form of policy that will impact sectors and earnings going forward, and in our view that has definitely introduced a downward bias on our multiple.”
In terms of opportunities, Boubouras says investors have got to “do their homework” among the sectors. “There are quite a lot of stocks that look fairly well-placed. We like BHP and Rio Tinto and Fortescue, we think they’re a good bet on the Asia story, and also in metals, we like Sims Metal Management. It’s the world’s largest metal recycling company, and we see it more as a US recovery play: it’s a way to buy the US recovery two years before the US recovers.’
In energy, Boubouras likes Woodside and AWE there, and Worley Parsons is a good energy exposure as well. Other resources stocks he sees as attractive are gold explorer Avoca Resources. Gloucester Coal, Macarthur Coal and we like African coal producer Riversdale Mining as a high-conviction, higher-risk theme.
In the financials, ANZ is his preferred stock, on the basis of its strategy in Asia, while he also recommends ASX and IAG. Of the pure cyclicals, he likes Aristocrat Leisure. “Aristocrat is a very cyclical stock, but we like it on the basis of the machine replacement cycle offshore. Onshore, we don’t like it, it’s a good example of that regulatory risk we’re talking about.”
In retail, Boubouras prefers JB H-Fi over Harvey Norman, and also likes Billabong. “Again, you’re buying Billabong for that US recovery story, and also good execution. And if you’re looking to play that US recovery story, we would say you also need News Corporation.”
In the defensive part of the portfolio, Boubouras says Wesfarmers is the stand-out. “We’d also say AGL is a preferred defensive, and so is Crown, from an Australian perspective. You need healthcare in there, and CSL always features as a core defensive holding,” he says.