David Walker

Written by David Walker, Senior Analyst, StocksInValue

The following article was published in The Australian


ASX investing in 2016 will be about the index’s composition, not its level. The index will be restrained by two of the same drags as 2015: lack of value due to low bond yields inflating equity prices, and underperformance by mining stocks, which accounted for 11 per cent of the ASX 200 by market weight on 30 September but will shrink to a single-digit weighting next year. The index is fully valued and we expect only a single-digit return in 2016.
Other than by picking the right IPOs, the best returns on the ASX next year will come from picking the stocks and sectors which increase their weighting as resources continue to decline in relevance.
The winners will either have exposure to Australian dollar depreciation (US dollar earnings), as we expect the currency to resume its slide, or to the strengthening non-mining economy. In our recent article, ‘Navigating the post-mining boom era’, we presented the ASX stocks and sectors which benefit as the domestic economy grows.
So you should ‘sell beta and buy alpha’. This means avoiding index investing, which will deliver only mediocre returns, and choosing active management, which in 2016 will be the only path to earnings returns which compensate for the risks of equity investing. Indeed this has been the case for the last nine years, as the index remains at levels of late 2006.
Banks are set for modest rallies. The four majors are still undervalued and, barring a more hawkish approach from the Basel regulatory capital process, can rally as mortgage lending continues to grow and business lending accelerates. The best bank to own is NAB for its sector-leading exposure to business lending and the tailwinds to return on equity from divestment of the troubled UK operations. Corporates have plenty of room to re-gear:
Figure 1
Figure 1. Business Finances
Sources: ABS; APRA; RBA
Commonwealth Bank is our second choice for its diversification, superior record of low-volatility earnings growth and strategic execution.
ANZ and Westpac rank last. ANZ screens as the cheapest bank but this is deserved, as the Asian expansion has not delivered any value that we can see. Bank returns on equity from Australian mortgage lending were higher throughout ANZ’s expansion in Asia but ANZ is now expanding in Australian home lending at the peak of the cycle and by price discounting, which concerns us.
Earlier, Westpac expanded the most aggressively in NSW and Victorian investor lending so has the most to lose from the current slowdown in these markets. Westpac needs more capital for this reason and because it raised $3.5 billion of new equity but then paid most of it out again in dividends.
There will be no housing collapse, hence our confidence in banks. House price growth will slow down but continue because interest rates remain very low. The theme is stagnation/cooling, not collapse. We do not expect the Reserve Bank to tighten until mid- to late 2016.
The upside risks to world inflation are in the tightening US labour market (and the UK to a much lesser extent) and the stability in oil around US$40 – 50. The heaviest falls in oil were a full year ago, so these falls will soon drop out of annual comparisons.
To preserve profitability and dividends, oil producers have slashed capital expenditure too far for the industry to meet demand growth in coming years, especially given the US’s much-vaunted shale oil wells have short production lives and need replacement sooner than traditional wells.
As the futures market realises this, oil prices should rally modestly next year, giving the industry incentive to resume exploration and development of new reserves. Low prices will be their own cure. Note the outlook for oil differs from the bearish outlook for iron ore and coal.
Australian dollar weakness will resume as bulk commodity prices continue to head lower on rising supply and weaker Chinese demand. BHP and Rio Tinto are both bearish on iron ore in 2016. Gina Rinehart’s Roy Hill just started exporting, adding to the surplus in the seaborne iron ore trade. Major miners continue to drive costs lower by increasing supply in an effort to drive out higher-cost production and increase market share.
We also expect the foreign exchange market will start to pay more attention to Australia’s worsening foreign debt position. High gearing and commodity exposure do not go well together.
The great opportunity for Australia is inbound tourism, especially from China. Australia has world-famous tourism assets when outbound Chinese tourism is compounding rapidly and the cheaper Australian dollar makes an Aussie holiday more affordable. We urge our politicians to lead a national conversation on this and how the country can best benefit from it.
This Christmas is shaping up as a good one for retailers but working capital pressures in retail will grow in 2016 as Australian dollar hedges at 80 US cents roll off and retailers pay more for imported inventory. Retailers which cannot pass this on to consumers could disappoint investors.
The building sector is experiencing the highest levels of residential construction in a decade but the market has fully factored this in. It’s time to ease out of residential construction stocks during share price strength. We recently sold the Brickworks position in our model portfolio.