Market Overview Australian Shares Australian shares were weakening even before the global late August squall and were always likely to travel badly when market conditions turned bumpy: o For the quarter, the S&P/ASX 200 Index produced a loss of 6.58%, which includes dividends As would be expected when concerns about Chinese growth have been prominent in recent events, the miners have fared especially badly, but most other sectors are also in the red for the calendar year The only sector (other than the Listed Property/REITs, discussed later) showing a calendar year to date gain is the industrials, where the lower value of the AUD is improving exporters' prospects International Shares World shares had been drifting downwards in any event through July and the first half of August, but the gradual decline turned into a sharp lurch downward from the 20 th of August onwards: o Prices did stabilise in early September but overall, it was a poor quarter for world shares For the September quarter, the MSCI World Index was down 7.72% in the currencies of the overseas markets: o For Australian investors, the even larger fall (8.72%) in the AUD against the USD turned the large loss into a small 0.20% AUD gain: Currency weakness has also had a marked effect on the calendar year to date performance, with the MSCI World down 3.39% but up 9.50% in AUD terms The immediate cause of the setback was the slump in Chinese share prices: o The Shanghai Composite Index had hit a peak of 5,166.35 on June 12, at which point it was up nearly 60% since the start of the year: But it then dropped sharply, to under 4,000 (on July 2) and to under 3,000 (on Aug. 25), before the Chinese authorities managed to halt its fall, mainly through a programme of concerted share purchases by public sector entities The weakness of Chinese shares in turn raised a range of issues for worried investors in the rest of the world that perhaps Chinese growth would no longer contribute as strongly to world economic activity or that financial stresses on Chinese banks and households might lead to another problem of the global financial crisis style. In the US, the S&P 500, which had been trading sideways around the 2,100 mark for most of the year, dropped as low as 1,867.6 on August 25, and, although it recovered somewhat to 1,920.0, it was down 6.44% for the quarter and 5.29% for the calendar year to date. Other major markets also had a bad quarter: o Japan's Nikkei was down 14.07% and European shares down 8.08%, with Germany down 11.74%, the UK 6.13%, and France 6.85% Emerging markets were sold off heavily: o Although some of the decline is attributable to the very weak Chinese share market, the other "BRIC" economies (India, Brazil and Russia) also did poorly Page 1 of 7
Market Overview Australian Property A REITs registered a small gain in the September quarter, 1.11% on a total return basis: o The even better news is that the A REIT sector has comfortably outperformed the wider equity market for the calendar year to date, with a total return of 7.90% compared with the S&P/ASX 200's negative 3.68% Australian Cash & Fixed Interest Yet again, short term interest rates are unchanged, with the Reserve Bank of Australia maintaining a steady monetary policy: o The cash rate has been held at 2.0%, and 90 day bills continue to trade around 2.15% 2.2% o Long term bond yields have once again tracked overseas trends very closely The global demand for bonds in the troubled world equity markets of late August was echoed in the local Australian market, where the 10 year Commonwealth bond yield reached a low of 2.5% on August 24 Since then, the local yield has followed the US market back up a bit, and the yield is now 2.61%. International Fixed Interest In the US, the 10 year Treasury bond yield has been backing and filling in recent months as markets have reassessed the likelihood and timing of a Fed tightening of monetary policy, the underlying American economic outlook, and the attractiveness of other asset classes o At one point (June 10), the yield got as high as 2.48%, but it subsequently dropped as low as 2.01% (August 28) at the height of global equity market volatility o The yield started to rise again and was back up to 2.06%, though it is still below its early June levels Bond yields in the other major markets have followed much the same pattern, with "safe haven" demand for bonds during equity turbulence driving yields down, particularly in August: o In the UK, the 10 year gilt yield was down to 1.76% from 2.01% o In the eurozone, the German government bond yield has drifted down a bit, to its current 0.59% from around 0.85% in the first half of June, as has the Japanese equivalent, which has dropped to 0.35% from around 0.45%. While government bonds from creditworthy countries have been in demand from nervous investors, less creditworthy bonds have been sold off: o Corporate credit spreads have generally widened, and bonds issued by emerging markets economies, which had previously been in strong demand as investors looked for alternative sources of yield, have fallen from favour Australian Dollar The Aussie dollar has weakened further: o After a period of stability in July and the first half of August, it started to drop again in later August and into September, and ended the quarter at US70.10 cents. Page 2 of 7
A number of macro factors are currently driving the Australian share market, with the S&P/ASX 200 Accumulation Index falling by 7.8% during the month of August. These include: Fears of a Chinese economic slowdown; Concerns over a potential interest rate hike in the USA, and Signs that Australia s economic growth could stall, with private investment failing to compensate for a slow down in mining capital expenditure As a result, the August reporting season will be remembered as a disappointing one, with downgrades to Australian companies earnings outlooks and limited growth opportunities going forward. The key points to come out of the June 2015 full year reporting season were: Earnings disappointments FY15 earnings per share growth fell by 1.8% with FY16 outlook downgraded from growth of 4.0% to 3.1%; Payout ratios rising companies remain focused on returning capital to shareholders, pushing payout ratios above highs last seen during the GFC; No standout sectors no sector posted an improving earnings outlook, with currency sensitive stocks also disappointing, despite the benefits of a falling $A. Earnings Revisions Pressure on top line revenue growth persisted over the 2015 financial year and whilst cost cutting remained the predominant theme, it was not enough to lift earnings. Earnings growth fell by 1.8% for the year with Resources once again the largest drag on earnings. Source: IBES, Bloomberg, Goldman Sachs Page 3 of 7
Downgrades for forward earnings were prevalent across the market, with only Building Materials, Health Care and A-REIT (Property) sectors revised higher. Source: IBES, Bloomberg, Goldman Sachs There also still remains a significant divergence between companies that primarily have domestic earnings and those that have offshore earnings. Although both groups contributed to the fall in earnings growth of the overall share market (ASX 200), domestic based companies delivered no earnings growth in FY15 compared to internationally based companies delivering growth of around 10%. Foreign exchange tailwinds (lower $A) and stronger underlying growth are likely to see this trend continue over the coming year, with earnings growth expected to average around12% for the offshore exposed stocks over FY16 compared to just 2.5% for the domestically based stocks. Capital Management The August reporting season also showed that companies continue to place high importance on capital management, including special dividends, capital returns and share buybacks. Given the challenging earnings environment, this was achieved primarily through an increase in payout ratios which have now returned to cyclical highs, suggesting there is limited scope for dividend growth going forward. Page 4 of 7
Source: City, IBES, RBA, CIRA With a general preference by management to return capital to shareholders, the reporting season saw a number of companies undertake share buybacks, which were encouraged by the market and rewarded by investors. We should see this theme continue into next year, which is also predicted to be a challenging year for company earnings. As such, a continued focus on returning capital to shareholders and attractive dividend yields will most likely provide a source of support to the broader Australian share market. Even with the recent market correction, equities remain attractive against bonds. The forward dividend yield for the S&P/ASX 200 has risen to an appealing 5%, with spread over bond yields at a 42-year high. Source: IBES, Bloomberg, Goldman Sachs Page 5 of 7
The Banks Significant Return of Capital While many companies returned capital to shareholders, the banks were at the other end of the spectrum, forced by the regulators to raise additional capital. While CBA was the only one of the four to report full year earnings during August, the banks certainly had an impact on investor sentiment. ANZ s announcement that it would seek to raise $3 billion in capital and CBA s subsequent $5 billion announcement later in the month dragged the financials sector lower during the reporting period. As a result of the increase in capital requirements, it is expected that dividend growth for the banking sector will slow over the years ahead. Major banks capital returns and issuance 2005-2015 Source: UBS However the banks are expected to continue paying relatively attractive forward dividend yields (currently between 5-7%) which will provide a degree of support given the low interest rate environment. While capital issuance has a negative impact on earnings per share growth, the banks financial results have been reasonable as per their last trading updates and therefore earnings are expected to hold up going forward. Page 6 of 7
Outlook The earnings outlook may have deteriorated, but we believe there are a number of factors that will support the market in the coming months. These include the relatively strong balance sheets supporting expectations that companies will focus on returning capital to shareholders, as well as forward dividend yields remaining attractive for investors relative to record low interest rates. In addition, the recent correction has taken the market s forward price-to-earnings (P/E) ratio back towards its historical long-term average. Yields push above 5% and valuations revert towards historical means Source: UBS Nevertheless, the recent share price volatility may persist over the near-term as a result of the uncertainty around the macro factors mentioned earlier in this report. However, based on recent data we believe the concerns surrounding Chinese economic growth and the impact of a US rate hike are overstated. In addition, while the economic landscape in Australia is lackluster, we do not expect the economy to fall into a recession. Therefore it is important to focus on companies that have strong fundamentals, are expected to increase earnings in a low growth environment and have a disciplined approach to capital management. Page 7 of 7