Retain Market-Weighting of Australian Equity Market

A 5.3 percent cumulative year-to-date drop in performance (in US dollar terms) of a Group of 20 (G-20) stock market would seldom attract investors’ attention or scarcely seem an important development in the context of broader year-end global volatility were it not for the exposure of the exchange to the cyclical fluctuations of overseas demand for its crucial exports of mined natural resources that engender domestic business activity and grow its foreign exchange reserves.

The market in question is Australia and – in spite of the fact manufacturing, not raw materials extraction, dominates its economy at about 88.5 percent – Asian (particularly, Chinese) demand for Australian mining and manufacturing products should proceed to concentrate investors’ attention on the ramifications of a further collapse in the prices of energy and industrial commodities on the price and total return of the country’s stock exchange in the near- and intermediate-term.

Australian equities may not be the worst performing market globally thus far this year.  Yet, the single-digit loss of value they have accrued since late 2013 in US dollar terms reflects not so much fragile commodity demand patterns as much as it mirrors deeper concerns among investors about the nation’s deteriorating fiscal outlook and weakening economic fortunes.  Indisputably, the sell-off in Australian shares commenced virtually at the same time (early September 2014) as the slump in raw material and energy prices.

Even so, descending commodity prices at most catalyzed Australia’s stock market sell-off, while – beneath the surface – fundamental factors for some time had been eroding investor sentiment and laying the foundation for a steep slump in equity valuations eventually.  The Australian credit market too is signaling a further slowdown in economic activity.  Although the sovereign yield curve has yet to invert, the sharp decrease in yields across the maturity spectrum [143 basis points (bps) on the twenty-year bond alone] in the past year may spell more trouble ahead for the national economy (Figure 2).

Forebodings of further macroeconomic weakness are apparent as well in the trends of leading indicators and purchasing managers’ indices of late.  The year-on-year rate of change in the former has plateaued at 2.7 percent, but Westpac’s index has been drifting down for over a year.  Furthermore, the purchasing managers’ index (PMI) is tenuously holding above the critical fifty level separating economic expansion from recession at 50.1 (Figure 1).  Additionally, the nation’s terms of trade continue to deteriorate with exports declining steeply and imports edging upward (Figure 3).

Looking ahead, the Australian economy, overall, is expected lose momentum next year, slowing to 2.5 percent from a projected 2.7 percent pace of advance in 2014.  A continued rebalancing of the economy from foreign to internal sources of growth will limit the expansion for most of the coming year before a rebound begins to take effect in the following year.

Over the next twelve months, the weakening effects of fiscal consolidation and contracting investment are likely to limit the upside impact of relatively firm private consumption and export growth.  In 2016, though, an anticipated recovery in business capital formation – together with strengthening household purchases, a moderately wider budget shortfall and a modest pickup in overseas demand for domestically-made manufactures, extractives and services amid a stabilization, or perhaps depreciation, of the Australian dollar (AUD) – should spur national growth slightly above three percent.

As the authorities in Canberra struggle to stabilize the AUD, the monetary policy of the Reserve Bank of Australia (RBA) will remain concentrated on stimulating economic growth by keeping credit policy loose through a series of official interest rate reductions in the period immediately ahead.  The RBA is expected to undertake two or more cash target rate cuts of 25 basis points in the next nine months – the key side-effect of which should be the exertion of downward pressure on the AUD.  Surplus commodity inventories and slack labor market conditions and surplus commodity stocks should maintain a lid on inflation regardless of AUD fluctuations.

On the fiscal policy front, meanwhile, the center-right regime, led by Prime Minister Tony Abbott, will labor to bring public finances under control amid attempts to satisfy the Liberal-National coalition’s campaign promises to lift spending with the aim of addressing several social issues.  While the government should meet its budget targets next year, 2016 – when the next nationwide elections are due – is expected to prove quite challenging for the incumbent regime.

The Australian stock market’s comparatively poor performance thus far this year (as gauged by the S&P ASX 200) is worse than that of either Asia excluding Japan or the world for that matter.  Australia’s 5.3 percent loss of value is 5.3 percentages lower than Asia excluding Japan at zero percent and 9.7 points below the S&P Global BMI’s gain of 4.4 percent.  Even though Australian equities appear inexpensive on either an absolute or comparative valuation basis, we are convinced their p/e has further leeway to compress, which rules out for now any consideration to overweight Australian stocks for the foreseeable future and affirms our decision to hold Australian shares as a market-weight in global portfolios.

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