Cautious optimism for market

Cautious optimism for market

Agribusiness
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The Morgans research team provides an update on key sectors and trends they see within the market.

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Boh Burima

Boh Burima

Recently the Morgans research team provided an update on key sectors and trends they see within the market. Australian shares approaching record highs are clearly being driven by long bond rates at record lows, and are in opposition to deteriorating profit growth expectations.

Investing in abnormal markets

Australian banks and high yielders enjoyed a relief rally post the surprise Australian Federal election result but Australian long bond rates plummeting to record lows below 1.3 per cent has been the major driver of Australian equities to near record highs.

This is a pure yield arbitrage story. With Australian equity yields (ex-Resources) of 4.3pc at decade lows, their premium over long bond rates (roughly 3pc) is currently at decade highs, supporting the share push to extreme valuations (currently 17.5 price earnings 12-month forward). What worries us is the ongoing erosion in profit growth expectations. This was a difficult 'confession season' this year with several larger stocks downgrading earnings guidance. That said, with the removal of federal election uncertainty, and with forecast financial year 2019 earnings growth now at zero, the market has set itself a very low hurdle to clear heading toward August results.

Industrials - Finding growth in a subdued environment

The domestic economic environment remains sluggish with consumers cautious notwithstanding historically low interest rates and future income tax relief. Labour and energy costs remain high and this is putting pressure on company margins despite ongoing efforts to offset this through improved productivity. Encouragingly however, house prices are showing signs of bottoming post the federal election. While still early days, if sustained, the flow-on effect from a better housing outlook should be positive for the rest of the economy and could kick-start an increase in consumer spending.

Regardless of the macro environment we continue to prefer high quality companies with proven management teams and a strong balance sheet. We also like companies that have some international exposure given the broader potential for growth. Orora (ORA) remains one of our key picks in the sector due to its defensive characteristics and North American exposure. Acquisitions can provide a boost and, in this regard, it is comforting to know that Orora has a strong track record. With a business model that performs in all conditions, Orora looks set for further steady growth.

Resources and energy - Cautious around trade uncertainty

We continue to advocate caution in resources, with the escalating trade dispute between the US and China still dominating headlines and triggering uncertainty around global growth. With no certainty of a deal being reached at the G20 meeting in late June, we continue to recommend investors remain patient when accumulating miners and energy stocks. The greatest risks, from a share price perspective, are around the so-far immune iron ore miners where valuations have become stretched (and China stimulus has shown signs of slowing) and oil and gas producers given the high correlation the oil price has shown to market views on global growth conditions.

In times of uncertainty global investors flock to two major safe havens: Gold and the global reserve currency of US dollars. With the China-US trade war and Brexit weighing heavily on the minds of investors, we have seen significant increases in the Australian dollar gold price (record highs), which has translated into very strong performances by local gold producers. In the large cap space we prefer Evolution Mining (EVN), which is a consistent, low-cost gold producer.

Conclusion

As a result the current economic conditions outlined above, the outlook for equity markets overall continues to be one of ongoing cautious optimism. We see the low interest rate environment supportive for risk assets over the medium term. We think an extended period of elevated valuations will persist until markets once again fret about rising interest rates. At this stage with inflation subdued this does seem a long way off.

  • Boh Burima, Financial Adviser (Authorised Representative: 000341081) Morgans Financial Limited | ABN 49 010 669 726 | AFSL 235410
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