Market Insights: Local equities still at the mercy of commodities

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.

Of course, with the decline in resource sector prices in recent years, the sector is not as important to the market as it once was. That said, the very large swings in earnings that are possible within the sector suggest it can still have quite out-sized influence on overall market earnings.

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.

Another challenge for resource sector price performances is the fact that valuations still appear quite high – implying the market is indeed counting on a speedy rebound in earnings. The current price-to-forward earnings ratio for the materials sector is around 20, compared with a decade average of 12.5 – it was last this high at the height of optimism regarding a market rebound from the financial crisis in mid-2009. At 15.5, even the S&P/ASX 200’s forward PE ratio is above its long-run average of 13.5.

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.

Popular Articles

Bassanese Bites