Is the gloom driving an equity boom?

Right now there is a general feeling of gloom in the Australian economy. 

Source: Bloomberg

Unemployment just rose to its highest level since August 2002 -6.4%; though the Head of the ABS estimates unemployment is ‘somewhere between 6% and 6.8%’, which could mean the figure is higher or indeed lower. Full-time job creation is crashing (again the ABS is struggling with seasonality here) and wage inflation is moving into disinflationary areas.

From a bottom-up perspective, earning season so far has seen EPS growth being marginal at best. Most of the results have seen solid revenues, yet the lofty price valuations that have been built into the share price in 2015 are rendering the revenue results void.

With the RBA now officially part of the interest rate war after having sharply reversed its stance on the economy, history clearly shows Australia is in for a least one - maybe even three more cuts in the next six months on the data currently at hand.

There was a slight suggestion that the spike in consumer confidence and the fact housing finance is rocketing forward would slow the RBA’s cuts. The interbank market on Wednesday fell to a 20% chance of a rate cut in March on this theory; however that has reversed sharply on the employment figures to close on Thursday at a 69.8% chance of a cut in March. There is a 100% chance of a 25 basis point cut by April according to the same market.

That would bring rates to 2%, however judging by the employment reads and the fact that the mining boom very clearly is over (Port Hedland house prices are plummeting and properties are even been handed in), there it a very real prospect of a 1 handle cash rate by December this year.

Why I see rates lower and into the 1% handle - ‘below trend growth’, in the words of the RBA. The ‘streamlining’ of business over the past 24 months has seen Australia, like the rest of the Western world, enter a lower growth paradigm. Businesses the world over are all about absorbing the current conditions, meaning EPS growth is likely to stay low, margins will remain soft and business expansion will be limited – this does justify the RBA’s current monetary policy stance.

Lower rates mean a lower AUD; it will also mean the current fund drive in the bond market is likely to stay for longer, plus the dividend yield compression in the ASX will stay lower for longer.

The flipside of the lower rates and lower AUD is that it will drive the ASX. The 12day streak in January showed very clearly that domestic and international investors are being pulled back into the ASX. The lower rates push bond and simple money market instrument (term deposits etc.) holders into the market as they look to maintain above inflation returns on a per annum basis. The AUD’s march lower on the back of rate cuts pulls foreign funds back into Australia. Although the market is stretched currently on a P/E basis, the current environment is likely to see this ratio remaining elevated. I see ‘fair value’ between 5650 and 5700 under the current conditions, however 5800 to 5850 isn’t out of the question if rate fall to 1.5% or lower.  

Ahead of the Australian open

Ahead of the open, we are calling the ASX up 54 points to 5798 as anticipation builds around Glenn Stevens’ address to the Standing Committee. He will be pressed on his decision to cut rates, what he now sees as the outlook for Australia and the likelihood of further cuts and which metrics are required to slow the current rate cut cycle.

In typical Glenn Stevens’ style, he will be very measured in his responses; the question however he will have to give some colour to the Board’s decision on February 3. It will be a major driver of the AUD and ASX today and signs that the rate cuts are imminent will drive funds back into the yield trade that has eased over the past four days.  

This information has been prepared by IG, a trading name of IG Markets Limited. In addition to the disclaimer below, the material on this page does not contain a record of our trading prices, or an offer of, or solicitation for, a transaction in any financial instrument. IG accepts no responsibility for any use that may be made of these comments and for any consequences that result. No representation or warranty is given as to the accuracy or completeness of this information. Consequently any person acting on it does so entirely at their own risk. Any research provided does not have regard to the specific investment objectives, financial situation and needs of any specific person who may receive it. It has not been prepared in accordance with legal requirements designed to promote the independence of investment research and as such is considered to be a marketing communication. Although we are not specifically constrained from dealing ahead of our recommendations we do not seek to take advantage of them before they are provided to our clients. See full non-independent research disclaimer and quarterly summary.

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