Investors see red for second year running

For just the second time in 30 years the Australian sharemarket is poised to deliver its second consecutive calendar year of negative returns. In what will be 12 months to forget for most investors, the combination of European debt woes and worries about the Chinese and US economies, along with the prospect of another bout of instability in the global banking system, have pushed the S&P/ASX 200 Index down 13.83 per cent so far this year.


The benchmark shed almost 3 per cent in 2010 and will record back-to-back negative calendar year returns for the first time since the benchmark has been used as measuring the performance of super funds, while the All Ordinaries Index is down 14.55 per cent so far in 2011, after a drop of 1 per cent in 2010.

The last time the All Ords posted back-to-back calendar year losses was in 1982 and 1981 when it fell 18.5 per cent and 16.4 per cent, respectively. According to UBS, over the past 50 years the All Ords has averaged one negative year every 3½ years.

And thanks to indecisive policy making in Europe that has failed to solve the problems, sharemarkets are likely to remain volatile over the next few months.

In this environment investors have flocked to defensive stocks that have been re-rated in 2011, sending their price-earnings ratios higher and making them expensive when compared with out of favour industrials.

Fund managers argue that most stocks are cheap when measured by book value and their earnings potential, but remain cautious.

“As we move into 2012 the risks are elevated versus this time last year. A cautious stance is warranted for the next quarter. However, there remains some very good upside in equities on a three-year-plus view when we look at a normalised earnings profile through the cycle,’’ says UBS Wealth Management director George Boubouras.

He adds that current equity valuations are significantly discounted but given the many global challenges, “equity valuations look set to remain compelling”.

Investors are predominantly focused on reconciling the daily global macroeconomic noise in their minds and that can be seen in the day-to-day price volatility that has whipsawed everybody. Investors have also gravitated towards stocks that pay healthy dividends, such as bank shares.

But Macquarie Equities strategist Neale Goldston-Morris warns that the banks are about to be hit by pressures on operating margins as it becomes more expensive for them to borrow in wholesale debt markets.

He says they will struggle to pass on the higher costs, which puts them on a collision course with Canberra.

“Dividend payment levels will likely come under pressure by the second half of the 2012 financial year,’’ says Goldston-Morris.

He recommends that investors cut back on their exposure to the banks, ANZ Banking Group and Westpac Banking Corp in particular, while Commonwealth Bank of Australia remains his preferred exposure.

The sell-off in stocks has resulted in the forward price-earnings ratio of the major index falling from 12.8 times earnings at the start of the year to around 10 times now. This has happened against a backdrop of an Australian dollar that averaged around $US1.03 in 2011, and a significant fall in the long-term government bond yield from 5.55 per cent to a record low of 3.74 per cent.

That means the implied equity risk premium for local stocks versus government bonds is almost 8 per cent. This is not quite as high as the 8.2 per cent it reached in 2008 but much higher than at any time in the past 20 years when it averaged around 4 or 5 per cent, signalling that shares are cheap.

Despite the appealing valuations, it’s not enough for some fund managers; they fear the process of deleveraging and unwinding the credit excesses of the past 10 years will take longer than many suspect.

The resources boom and the best terms of trade in 100 years failed to stop the selling. Surprisingly, the Dow Jones Industrial Average is in positive territory and heading towards its third consecutive year of gains.

Australia is becoming more linked to Asia, where the Shanghai benchmark is down around 22 per cent, Tokyo’s Nikkei is 17 per cent lower and Hong Kong’s Hang Seng has fallen about 19 per cent.

Hindsight is often described as a wonderful thing. Looking back on 2011 it is clear that many economic and financial forecasts were too optimistic.

Many experts had economic growth coming in at 3.5 per cent in 2011 and unemployment at 4.5 per cent by the end of the year, with the cash rate at 5.5 per cent and the major index as high as 5400 points.

The European debt crisis and a number of disasters – floods in Queensland, an earthquake in Japan that led to a nuclear disaster, and a quake in New Zealand – all helped put these forecasts way off track.

In fact, the economy has expanded 2.75 per cent in 2011, while unemployment is likely to be closer to 5.25 per cent and the cash rate has been dropped to 4.25 per cent, with most experts tipping further cuts.

The good news is that inflation will probably end 2011 near the forecast of 2.75 per cent.

But the domestic economy, already under pressure from the imbalances generated by the resources sector, faces a number of challenges including the high Australian dollar and stretched housing affordability along with household debt and fiscal consolidation.

Westpac chief economist Bill Evans says these factors suggest the consumer, housing construction and public investment will all restrain growth.

“In short, the risk is that growth will persist at a sub-trend pace for a little longer,” says Evans.

As a result, Westpac has lowered its forecast growth for the year to December 2012 to 3 per cent from 3.5 per cent. It forecasts that the Reserve Bank of Australia will cut rates by another half a percentage point to 3.75 per cent, beginning with a move to 4 per cent in February when the RBA meets next.

As the US and Europe confront the twin burdens of sovereign debt pressures and minimal growth prospects, investors are turning to the emerging and Asian markets for their growth prospects. For those who think the local market might be a shining light in 2012, Merrill Lynch strategist Tim Rocks has got some disappointing news. He thinks the major index will be at 4200 by this time next year.

A major factor why Australian shares have done so badly is the greater exposure to two of the weakest global sectors over the past year – financials and materials.

The materials sector, which houses Rio Tinto and BHP Billiton, is down around 25 per cent and the financial index has shed about 10 per cent.

Financials make up around 37 per cent of the S&P/ASX 200 Index compared with only 13 per cent of the United States’ S&P 500 Index, making this exposure almost three times as large.

Only two sectors closed in the black: utilities and telcos. Telstra has had a stellar year, gaining 19 per cent, thanks in part to its dividend and hopes the national broadband network deal will allow the company to start afresh.

Despite the doom and gloom there were some winning stocks. Sigma Pharmaceutical was the stand-out, up 115.4 per cent, with Iluka Resources adding 71.7 per cent and Mesoblast, 57.2 per cent.

On the other side of the ledger, White Energy was the worst performer, dropping 88.8 per cent. Energy Australia plunged 83.7 per cent and BlueScope Steel shed 78.5 per cent.

Written by Philip Baker (Source from the Australian Financial Review)