The biggest one-day fall in shares in four weeks may mark the start of the elusive midyear pullback.
Australia’s benchmark S&P/ASX 200 index fell 1 per cent to 5323.2 points on Wednesday — the biggest fall since May 4 — with the resources sector leading broadbased falls as oil and US shares faltered.
The index was unusually strong last month, up 2.4 per cent versus its 10-year average of a 3 per cent fall for May, as oil prices rose, the Reserve Bank cut interest rates and the Australian dollar dived. The index has risen for the past three months, a feat not seen since late 2013.
After diving 21 per cent from April 2015 to February this year, the index rose more than 15 per cent from its February low.
But a slight rise in earnings expectations for the year ahead didn’t stop the market’s price-to-earnings ratio hitting 16.4 times — near the 25-year high it struck when the index peaked near 6000 points a little over a year ago, and a further recovery in earnings is far from certain.
While further interest rate cuts may push more funds from term deposits and bonds to shares, the proximity of the official cash rate to zero and the prospect of an eventual rise in interest rates globally — the US Federal Reserve has already started hiking and has flagged more hikes this year — will make investors wary of buying shares after such a strong run.
And while the Australian economy was far from recession last quarter with a stronger-than-expected 3.1 per cent year-on-year rise, the increase was purely due to a surge in net export volumes.
Moreover, while low inflation could trigger more interest rate cuts, if they go much lower investors will increasingly fear there’s something seriously wrong with the economy.
And the resurgence in Sydney house prices last month suggests that any further cuts in interest rates will risk reigniting the housing bubbles in Sydney and Melbourne.
Deutsche Bank equity strategist Tim Baker says he’s concerned about a potential midyear pullback.
“Australia has outperformed global peers over the past six months, bucking the trend of the past three years,” he says. “This is largely driven by a price-to-earnings rerating rather than earnings — Australia’s PE ratio is now 10 per cent expensive versus history. And Australia is still a clear outperformed on a long-run view, which wouldn’t suggest more relative upside.”
Baker notes that resources have driven a lot of the market’s rise this year, with improved momentum in China taking commodity prices higher. However, spot iron ore has fallen 25 per cent in recent weeks, and China’s monetary stimulus looks to be unwinding, which is understandable given the country’s large debt load.
And the high price-to-earnings stocks have also been key contributors to a firmer sharemarket, outperforming by 7 per cent this year. While strong earnings growth has helped, there’s been a significant price-to-earnings rerating. Stocks that weren’t expensive relative to other stocks in 2015 have broken away this year to be 15 per cent expensive relative to history, according to Baker.
Backing up such concerns, the head of the nation’s Future Fund warned of “elevated risks” as the world struggles to recover from the global financial crisis, explaining the fund’s big move into cash.
David Neal, managing director of Australia’s sovereign wealth fund, says policymakers are not in a position to respond should economic conditions take a turn for the worse.
“What is different today is the world is ill-equipped to cope with a shock,” Neal said at the Australian Stockbrokers Conference in Melbourne.
“Central banks have fired many of their policy bullets — both conventional and unconventional — and with less ammunition they have less scope to respond to new shocks.”
Cash became the biggest single asset class in the Future Fund in March. The most recent March quarter numbers revealed cash investments at 22.9 per cent of the portfolio, up sharply from 15.1 per cent at the end of September.
“We see a low-growth environment, with low prospective returns, elevated risks and limited capacity for monetary policy to respond should things go wrong,” Neal says.
Baker says clients should consider buying AGL, Suncorp, Healthscope, Stockland, Coca-Cola, Estia, Mirvac and Duet because of their relatively attractive valuations, dividend yields and upward momentum in earnings.
GXY Price at posting:
48.5¢ Sentiment: Buy Disclosure: Held
