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Australian equities: the future is bright down under

Coal mine in Upper Hunter Valley, New South Wales, Australia

Australia is often called The Lucky Country, after a 1964 book by Donald Horne. It avoided a recession for over 28 years. This run came to a sudden, Covid-19 inspired halt in the second quarter as GDP shrank 7% following a 0.3% drop in the first quarter. However, the future might be quite bright for the Australian economy and Australian equities. Health situation is rapidly improving. Fiscal and monetary authorities are working together to support the economy, and we have lately seen an uplift in corporate earnings estimates.

Brief introduction to Australian equities

For the period between 1900-2018, Australian equities have recorded the highest real returns in USD terms of all major stock markets, at 6.8% per year, according to the 2020 Global Investment Returns Yearbook published by Credit Suisse. This was achieved with the second-lowest level of risk, or standard deviation, of 17.5% per annum.

When it comes to dividend yield, Australia stands out as one of the few places in the world still offering attractive yields. At the end of 2019, it trailed only the United Kingdom among the major developed stock markets.

Sector and stock concentration problem

One of the inherent disadvantages of the Australian market is its sector and stock-level concentration. For example, the top 10 stocks make up 40% of the ASX 200 Index and two sectors, financials and materials, together account for over 45%. Furthermore, 5 out of the top 10 are banks. Current situation is not an isolated episode. According to the RBA, financials and resources have comprised more than 50% of the index over the past 100 years.

Another side effect of the sector composition is the tendency for the Australian market to skew towards value names. Technology sector comprises less than 4% of the market.

Australian equities: light at the end of the tunnel

Covid-19 hasn’t been kind to the Australian stock market, given its composition. However, there are reasons for optimism:

Financials could surprise to the upside

The financial sector is critical to the performance of the Australian stock market. Due to the introduction of IFRS 9, a new accounting standard, banks have to provision for future losses upfront, as opposed to after the fact. Provisioning for Covid-19 losses was done in April and May, close to the peak of the first wave in Australia. According to Perpetual’s Anthony Aboud, this was likely too conservative. This could mean that earnings come in ahead of expectations, sustaining dividends at a high level.

Health and economic situation

Australia has done a good job managing the health impacts of Covid-19. Victoria, the epicentre of the second wave, has seen a significant drop in cases in recent weeks. After two months of lockdowns, the state started to re-open. There are some indications that internal state borders might be progressively re-opened, which would benefit the economy.

On the economic front, housing has been improving, and the unemployment data for August surprised to the upside, falling from 7.5% to 6.8%. Based on this print, economists at JP Morgan lowered the projected peak unemployment rate from 11% to 9.2%.

Fiscal and monetary support

The Reserve Bank of Australia (RBA) and the Government have been working together to deliver fiscal and monetary stimulus. In fact, in the first months of the pandemic, the Australian Government has provided the strongest direct fiscal stimulus among the G20 countries.

The budget released earlier in October suggests further expansion of fiscal policy. Budget deficit, expected at AUD$213.7 billion (USD$151.8 billion) for the fiscal year ending June 30, 2021, is hard to comprehend. In other words, it is 11% of GDP, more than three times the record from the financial crisis, and in terms of GDP the highest level since the World War 2.

Monetary policy has been equally accommodating, and there are expectations of further easing.

China remains a wildcard

Australia and China have a complicated economic and political relationship. Recent Chinese actions on beef, barley and wine are certainly a cause for concern. But the largest and by far the most crucial export is iron ore. Australia accounts for more than 60% of the Chinese iron ore imports. Given the scale, it is hard to imagine a meaningful deterioration of the relationship from here.

Overall, the Australian stock market is worth considering. The financial sector could be on the road to recovery, and economic activity is better than expected. Additional fiscal stimulus could support a style rotation in Australian equities, benefiting value stocks. However, investors should keep in mind the stock and sector concentration risks when considering the Australian market.