Australian equity fundamentals drive improvement in asset class view

JANA has recently completed its quarterly Asset Allocation review with the most notable change being an improvement to the view on Australian equities. The view of Australian Equities improved from Unattractive to Neutral. As a reminder, JANA determines asset allocation views based on three key areas being: fundamentals, valuations, and sentiment. JANA’s Capital Markets Group ultimately determine the relative view for each asset class.  While we believe the backdrop is more constructive for Australian Equities in isolation, it is important to note that the change in view is also a relative consideration and represents a recommendation for ‘reallocation’ of risk exposures, rather than an outright increase in risk for diversified portfolios.

Australian Equity – Fundamentals

In evaluating market fundamentals, the Australian Equities Research Team (AERT) evaluates the underlying earnings of the market and at a sector level both on an historical and on a forward-looking basis. In understanding the trend in earnings, AERT engages with fund managers across the market to gauge their views on the earnings outlook with a focus on the upside and downside risks over the next 3 years, with a particular focus on the next 12-18 months. AERT also observes the consensus earnings expectations from the sell-side in determining our fundamental view.

The underlying earnings and dividends for the ASX 200 illustrated below represents the sell-side consensus view for calendar years 2021, 2022 and 2023. The strong rebound in earnings of the ASX 200 from March 2020 is observable, as general expectations for earnings improved given the Federal Government support followed by the announced COVID-19 vaccine in late 2020.

Fundamentals for Australian equities are improving, driven by the earnings expectations of the major Miners and Banks to a large extent.

Major Miners

The ASX 200 Materials sector represents c20% of the ASX 200 index and therefore is considered a significant driver of broader market earnings. When considering the outlook for Materials sector earnings, AERT gathered the views from several Materials sector analysts from a range of buy-side managers. General observations are summarised below:

• Managers consider there to be significant upside risk to consensus earnings for the Resources sector forecasts in CY21 and CY22 given the differential between the iron ore spot price and consensus iron ore price expectations.
• Iron Ore Price: Spot iron ore price is trading at cUS$200/tonne in June 2021.
• Consensus iron ore forecast: CY21 US$140/t, CY22 US$105 and FY23 US$80. On current spot price, large cap Miners are expected to produce above consensus earnings margins, net profit, and dividends in CY21 and CY22.
• Analysts expect the supply of iron ore to remain below Global demand in CY22 driven by expectations that Vale won’t achieve its CY22 production targets.
• China has placed pressure on speculators trading iron ore futures as well as proposing steel production limits across two of the biggest steel producing provinces – iron ore price retreated on the back of both headlines but has since rebounded.

Major Banks

ASX 200 Financials sector represents c30% of the ASX 200 index and therefore is considered a significant driver of broader market earnings. Managers generally believe Bank share prices fully reflect their strong balance sheet positions. Future EPS growth comes with execution risk around improving earnings margin, cost-out initiatives and volume growth driven by business lending.

• Credit Growth: Housing credit growth continues to improve, particularly for the smaller regional banks. Business credit growth is more subdued but expected to rebound as the re-opening of the broader economy eventuates.
• Net interest margin (NIM = spread between consumer deposits and loans issued that Banks earn; a key profit driver for stocks in the sector): Major Bank NIM avg. 1.9% and likely to stabilise at these levels over medium term. Rising interest rate and steepening yield curve will benefit NIMs over the medium term.
• Capital Ratios: Banks are holding excess tier 1 capital (avg. per Bank: 11-12%, relative to APRA benchmark of 10.5%). The additional capital is expected to be distributed to shareholders over the next 1-3 years in the form of dividends and buybacks.
• Dividends: Dividend payout ratio to remain between 65-70% with buy-side managers anticipating yield for the sector building to 5%-5.5% fully franked by CY23.

Overall, managers are quite positive on the prospects for the market and the fundamental underpin for it.  AERT recently surveyed a range of managers, with 45% indicating they were bullish on the prospects for the market based on underlying fundamentals or valuations, while just 5% indicated they were bearish at present.  A neutral view was submitted by a further 45% of investment managers. Drilling into the details, managers are generally viewing upside risk to consensus earnings (below, left) and dividends (right) estimates for calendar years 2021 and 2022.

Valuations

The ASX 300 is trading on 18.6x forward P/E versus an average of 14.4x. Based on this measure the valuation appears expensive compared to historical averages, being just below +2 standard deviations expensive relative to long-term history.  Healthcare, IT, and Industrials remain the three most expensive sectors, with forward P/E being >2 standard deviations expensive.
Small and Mid-Cap segments remain elevated (trading at 2 standard deviations and 1.5 standard deviations above their averages, respectively), though Mid-Caps have notably fallen from the extreme highs experienced towards the end of 2020 (partially due to stock specific factors).

There has been divergence between the valuation of Small/Mid-Cap segments of the market when compared to the broader market, with the former displaying more expensive valuations.

Considering manager expectations for Fundamentals and earnings in FY22, Valuations on a FY22 basis don’t fully reflect those expectations. Managers expect the FY22 Market P/E multiple to compress given the expected improvement in Market earnings, all things being equal.

Sentiment

The NAB Business Survey in May saw highs hit in its indicators for business confidence and business conditions. Of note, the underlying factors, trading conditions, profitability and employment all hit record highs in the Survey. The largest increases were seen in the Mining, finance/business/property, and the services sector, although all sectors reported positive conditions. Confidence improved in all industries, led by a pickup in retail.

The Australian Equities Research Team recently undertook a survey of several managers. The key takeaways from the survey were:

• 91% of managers see an ‘average’ or ‘above average’ opportunity set over the next 12 months.
• The opportunity for ‘value’ segments of the market remains more favourable than ‘growth’ sectors.
• Key risks to these views are the emergence of inflation and a reduction in efficacy of vaccines.
• Movements in sentiment (based on 50-day moving averages relative to 200-day moving averages) across both mid and small cap stocks have moved in line with the broader market.

Conclusion

The fundamental backdrop for the Australian equity market remains robust driven in large part by the improving earnings outlook for the Mining and Financial sectors. Fund managers surveyed by JANA consider there to be earnings risk to the upside in FY22 relative to the consensus outlook.
Managers expect the FY22 market P/E multiple to compress given the expected improvement in market earnings all things being equal. Sentiment for the market also remains positive and provides support for JANA’s improved view on the asset class.