Australia: Australian Equities - Economic & market outlook

Banks

Conditions have been very favourable for the banking sector given the low interest rate environment, strong demand for residential property loans and benign level of bad debts. The strong level of bank profitability however hides significant looming risks. Unfortunately house prices (certainly in Sydney and Melbourne) are in bubble territory and household debt is at or near record levels, which means the risks for lenders (banks) are clearly rising. Loan defaults would escalate if we either see a sharp rise in interest rates (a 2% increase would result in a 40% increase in mortgage repayments) or a moderate rise in unemployment. Although a sharp rise in interest rates does not currently look likely, a moderate rise in unemployment cannot be ruled out given Australia's uncertain economic outlook.

Resources

Despite sharp falls among the miners, valuations based on current spot prices imply further downside risk if commodity prices stay lower for longer than most analysts expect. Given the significant overinvestment in property and infrastructure in China, the risk of a protracted downturn cannot be ruled out. As a result we remain cautious on the sector in the near term.

Infrastructure & Utilities

The low interest rate environment has heightened demand for perceived lower risk yield based investments such as infrastructure and utilities. Valuation metrics now look stretched (well above long term averages) for many stocks in the sector.

Cyclical Industrials

With most sectors screening as expensive on valuation metrics, this is one of the very few sectors that still offers value. Typically earnings in this sector can be reasonably leveraged to any incremental improvement in demand. As an example, stocks exposed to residential housing construction have already appreciated but the approval process significantly lags construction activity so further profitability is likely. On the flipside, these stocks tend to react very quickly to any bad news and can turn negative well before peak profitability is reached.

Australian Real Estate Investment Trust (AREITs)

The demand for yield has led to sharp gains in AREIT share prices in recent years. The demand has not just been domestically driven either. Overseas investors have shown a particular interest in residential and commercial property, helping to boost asset prices. This has occurred despite relatively subdued fundamentals. Office and industrial markets are generally suffering from an excess of supply. Bricks and mortar retail is suffering from the duality of below trend sales growth and convenience of online shopping. Residential markets are either suffering from the downturn in mining (Brisbane and Perth) or the bubble that is Sydney and Melbourne. Notwithstanding, those quality property trusts that have relatively low debt and long term leases in place in areas of high employment should continue to perform well.