ASX 200 breaks the 6000 barrier where to from here for Aussie equities

This week saw the S&P/ASX 200 index exceed 6000 for the first time since the onset of the Global Financial Crisis. This achievement is somewhat overdue, especially as the index was sitting at 5957 at the beginning of May. In fact, the Australian market has been the laggard this year, rising by just 5% year-to-date (YTD), while the MSCI and S&P 500 have rallied by around 15%. The underperformance of the ASX has occurred despite strong company earnings growth. Company earnings-per-share (EPS) of the ASX looks set to grow by around 11% over 2017, according to IBES estimates, the same growth rate as for the S&P 500.

Neither have movements in real interest rates (important to equity investors in their assessment of the appropriate discount rate to apply to EPS when formulating their fair-value estimates of stock prices), differed between the Australian and US markets, with the real 10-year bond yield in both markets showing zero change YTD. However, what matters to equity investors today is not what has happened over recent history, but rather what is likely to happen going forward.

Looking forward, a different picture emerges around the fundamentals of the Australian and US stock markets. Let’s begin with the outlook for EPS. According to IBES, EPS growth for the ASX is estimated to fall from 11% in 2017 to just 5% in 2018. In contrast, EPS growth for the S&P 500 is expected to remain at its 2017 rate of 11% in 2018. As we have been moving through 2017, equity investors will have been factoring in the weaker expected EPS performance of the ASX. Our view is that the differential in forward earnings estimates between the Australian and US markets could potentially explain around half the underperformance of the ASX over 2017. What explains the other half of the ASX’s underperformance? Over 2017, we have witnessed an expansion in the S&P 500’s 12-month forward price/earnings (P/E) multiple from 17.0 to 18.1 currently. The expansion in the S&P 500’s P/E multiple accounts for about a third of the increase in the S&P 500 index YTD.

In contrast, the P/E multiple of the ASX has been flat over 2017. A rise in the P/E multiple means that the earnings yield (the inverse of the P/E multiple) required by investors to hold stocks has fallen. This can occur either because the real risk free interest rate has fallen, and/or investors’ risk appetite for equities has increased. The risk-free interest rate (often proxied by the 10-year government bond yield less the 10-year expected average rate of inflation) underpins the yields of all assets. Investors’ risk appetite is expressed in the level of the equity risk premium; i.e., the excess return investors must receive to induce them into investing in risky equities instead of less risky government bonds. Over 2017, the US real 10-year government bond yield is unchanged, meaning the fall (rise) in the S&P 500 earnings yield (P/E multiple) is consistent with a fall in the equity risk premium. In contrast, both the ASX’s P/E multiple and real government bond yield is unchanged over 2017, suggesting there is little evidence of a change in investors’ risk appetite for Australian equities.

So what can we expect from equity markets over 2018 and will the Australian market continue to underperform? At QIC, we expect a more difficult environment for both the Australian and US equity markets over 2018. However, we expect the Australian market will outperform the US market over the coming 12 months. We think that US earnings expectations will disappoint over 2018, as earnings growth of 11% proves difficult to achieve in the face of rising wage growth and plateauing US and global economic growth. We expect a healthy, but more modest, rate of earnings growth of between 5% and 10% over 2018. The combination of earnings disappointments and gradually rising interest rates will pressure stretched US valuations leading to a drift higher in the US equity risk premium over 2018. However, we think the US equity market will avoid a hard landing. The ongoing recovery in the global economy, the passage of Trump corporate tax cuts and a gradual approach to rate hikes by the Fed will provide an offset to earnings disappointments, rising real interest rates and a cooling of risk appetite.

In contrast to the US, EPS growth estimates of 5% over 2018 for the ASX are more in line with the prospects for the Australian economy. With equity valuations less stretched in Australia than in the US, and with the RBA poised to lag other major central banks in the current phase of policy tightening, we see less downside to the Australian equity market than we do for the US. While we think 2018 will potentially see the ASX outperform the S&P 500, the impacts of a deleveraging household sector, a slowing housing market and a retracement in bulk commodity prices on Consumer, Real Estate and Mining stocks, will mean the S&P/ASX will struggle to improve on its 2017 absolute performance.

Table 1: Financial market movements, 2 – 9 November 2017

Equity index

Level

Change

10-yr government bond

Yield

Change

Foreign exchange

Rate

Change

S&P 500

2,584.6

0.2%

US

2.34%

-0.3 bps

US Dollar Index (DXY)

94.44

-0.3%

Nikkei 225

22,868.7

1.5%

Japan

0.03%

-2.5 bps

USD-JPY

113.47

-0.5%

FTSE 100

7,484.1

-0.9%

UK

1.27%

0.5 bps

GBP-USD

1.315

0.7%

DAX

13,182.6

-1.9%

Germany

0.38%

0.3 bps

EUR-USD

1.164

-0.1%

S&P/ASX 200

6,049.4

2.0%

Australia

2.60%

-5.3 bps

AUD-USD

0.768

-0.4%

 
Source: Bloomberg

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