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Overview
After an eventful and challenging year for the domestic equity market, we have a constructive view for 2021.
Underpinning our confidence is the forecast recovery in earnings that is anticipated across the next two years. COVID-19-driven shutdowns led to a sharp contraction in profits in the second half of the FY20 financial year and these extended into the December half, particularly in Victoria.
Australia’s success in suppressing COVID-19 has minimised the near-term earnings risk that escalating case counts would entail, while providing a more conducive environment for households and businesses alike.
The decline in earnings across the market has been broad-based in nature, with only a select group of companies benefiting from the enforced lockdown. The structure of the Australian market, however, with large sector weightings
to those that are more cyclical in nature, such as financials and resources, also led to weak relative performance compared to many overseas markets.Australia’s success in suppressing COVID-19 has minimised the near-term earnings risk.
Through the recovery phase, though, this should ensure a sharper rebound and has been reflected in positive earnings revisions in the last few months. Banks will be supported by falling bad debts and a rebound in lending growth; rising markets help diversified financials; profits in the resources sector will be aided by demand growth not only from China, but also developed economies; while consumer-driven industrials are poised to benefit from pent up demand for services, a rebound in employment and the build-up in household savings over 2020.
Throughout 2020, investors in the Australian equity market were dealt the further blow of aggregate dividend payments declining by more than earnings. This can be attributed to several factors, including a cautious approach by companies in the face of a high level of uncertainty; regulator-enforced capital retention for the major banks; and prevailing high payout ratios leading into the crisis. While not returning to FY19 levels, we expect dividends to show a stronger recovery than earnings this year.
The rare combination of coordinated fiscal and monetary stimulus is the final piece of the puzzle. The Federal Government’s response has limited job losses through the crisis period and has left household balance sheets in an improved shape, while the RBA has cut the cash rate to 0.1% and commenced a quantitative easing program. Critically, both the government and the central bank have telegraphed a clear message to the market that stimulus measures will remain in place for the foreseeable future.
Tempering our optimistic view is the starting point for valuations, with the forward PE ratio of the market at an elevated level. However, we don’t believe that valuations look stretched considering both the earnings environment and the expectation that interest rates will remain contained through the year. We hence enter 2021 with a tactical overweight to the domestic market.
Equity Market Performance Since Peak
Source: Bloomberg
While Australia contained COVID-19 cases better than most countries, the domestic equity market still lagged global equites since the peak in markets in February.
ASX 200: Cumulative EPS Growth
Source: UBS, FactSet
A strong rebound in earnings is anticipated across the next two financial years, with FY22 earnings expected to be at a similar level to FY19.
Australia Household Saving Ratio
Source: ABS, Bloomberg
Despite the recession experienced by Australia in the June half, household balance sheets are in good shape on the back of government support payments and a decline in services expenditure. The household saving ratio spiked from 5% to 22% in six months, the highest rate in more than 40 years.
