Strategy & outlook

Amongst the lively prose in this week’s RBA’s quarterly Statement on Monetary Policy were some useful figures on equity market valuation and the outlook for share market drivers.

PE ratios and yields seem to be around about long term average levels. Our PE ratios are consistent with the rest of the world but yields measurably higher; likely a reflection of our dividend imputation system.

According to the RBA, analysts are forecasting EPS increases of 14% for the ASX200 in the 2006/07 year but only 7% in 2007/08.

Meanwhile leveraged buyout (LBO) activity is seen as a key driver of recent performance with the central bankers citing the relatively low cost of debt compared to ROE. Even though we saw three rate hikes last year, long term bond yields remain low. The Bank believes excess demand is the primary reason long term rates remaining so low (10y yields 40-45bp under cash). Reflecting some level of concern about the private equity jockeys the bank points out that excessive leverage increases the risks to macroeconomic stability.

The outlook for commodities, specifically metals and energy is of critical importance. In the past three months we have seen 25% falls in copper and oil, partially reflecting a deflating speculative bubble but also some changes to the supply/demand dynamics. Growth in copper production now exceeds growth in demand. With new supplies for coal and other commodities coming online in the next 12-18 months the Bank believes we are unlikely to see much more price growth from any of these minerals.

Lastly, the outlook for inflation has the headline rate expected to fall below 2% by mid year. If this occurs then my pick is that rates could begin falling sometime late in 2007 or early 2008. With overseas rates increasing (Europe, for example) and a likely drop off in commodity prices over 2007/08 the AUD can be expected to fall over 2007 making this an excellent time – as I’ve mentioned before – to start diversifying out of the Australian equity market and getting into overseas markets, unhedged, or choose stocks with significant offshore exposure and revenue streams.

While the profit growth prospects for the Australian market generally are good for 2006/07 results, 2007/08 is modest (7%). From about now on, markets will be looking to 2007/08 numbers for valuations. If the outlook statements from the current reporting season suggest earnings growth greater than expectations then the market should hold up for another few months but beyond that I think we have to seriously question where additional growth and momentum in earnings – for the market generally – is going to come from.

The ‘weight of money’ thesis argues that the large volume of funds pouring into super and other investment vehicles will keep the market buoyant. That’s true but only to a point. As soon as returns disappear or the risk increases the money will look for a better home. Right now the tolerance for risk is high, evidenced by very low credit spreads and low volatility in the markets so the money is flowing in but that could reverse quickly – don’t get caught looking the other way when it does!

Currently I’ve got 20% international equities, 65% Australian equities and 15% cash. I’d be happy seeing overseas rise to 25% or even 30%. Disagree? Leave a comment!