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The Australian equity market has faced significant hurdles over the past year or so, with none more challenging than the sharp slump in export commodity prices. The challenge for the market in the coming year is that analysts still expect a sharp turnaround in resource sector earnings, which may be difficult to achieve if commodity prices remain low.
Resources Weigh on Earnings
As we have warned for some time, it’s been hard for the local equity market to rise in a sustained way against the backdrop of weak corporate earnings. As seen in the chart below, overall forward earnings for the market have been broadly flat for the past five years, with a declining trend even evident in the past year or so due to the accelerated decline in resource sector earnings. Outside of the resource sector a gradual pick-up in forward earnings has been evident over recent years, though even here earnings did slip back slightly over the past twelve months.
In the twelve months to end-February, resource sector forward earnings (calculated as the market-cap weighted average of material and energy sector forward earnings) fell by 41%, while non-resource sector forward earnings declined by 0.8%. Overall, forward earnings for the market declined by 8.8%.
Looking at sector performance in detail over the past year – and apart from the obvious slump in resource sector earnings – the stand out performers have been industrials, health care and listed property. In turn, this largely appears to reflect the benefits of low interest rates helping property valuations, while the weaker $A has helped boost the value of offshore earnings in the industrials and health care sectors. Increasing competition also hurt earnings in the consumer staples and telecommunication sectors.
Is the Worst over for Resources?
In view of the major slump in commodity prices in recent years, it would be tempting to suggest the worst might soon be over for the sector. To some extent, resource companies do have some earnings upside – due to both the likelihood of further weakness in the $A (which boosts the value of offshore earnings), and ongoing expansion in resource export volumes over the coming year.
That said, as seen in the chart below, forward earnings in the materials sector (which accounts for 75% of the resources sector) still remains critically dependant on the outlook for commodity prices. According to Bloomberg current consensus earnings estimates, forward earnings in the materials sector are expected to rise by 36% over the coming twelve months, which seems a big ask if commodity prices don’t rebound solidly.
As seen in the chart below, even though the resource sector (comprising materials and energy) now accounts for only around 16% of total market capitalisation, it is expected to contribute almost one-half of the growth in market forward earnings over the coming year. In short, the market’s earnings outlook still remains heavily dependant on a somewhat questionable rebound in commodity prices.
S&P/ASX 200 could struggle
All up, with valuations far from cheap and earnings still under some downside risk, it is hard to be super bullish on the market at current levels. It is for this reason I retain a relatively cautious investment stance. Investors who have a similar view might consider defensive income focused investments for their local equity market portfolio – such as the BetaShares Australian Dividend Harvester Fund (managed fund) (HVST), or the BetaShares Australian Top 20 Equity Yield Maximiser Fund (managed fund) (YMAX).
More bearish investors may want to consider the BetaShares Australian Equities Bear Hedge Fund and Strong Bear Hedge Fund (BEAR and BBOZ respectively) for a component of their portfolio, which aim to post returns that are negatively correlated with the Australian equity market.