(February-2002) 2002: What’s hot…what’s not

The majority of economists seem to agree that Australia has probably avoided falling into a recession, but they expect the most testing period to arrive around the middle of the year when the current house building boom runs its course.

Many echo the sentiments of Ausbil Dexia director of equities Paul Xiradis whose outlook for this year is premised on the expectation that “the recovery in Australia will be earlier and stronger than in most other parts of the world, driven by easier monetary and fiscal policy setting and a competitive Australian dollar”.

“The Australian profit outlook, as well as economic growth, appears to be much safer and more solid than other parts of the world,” he says.

Indeed, the International Monetary Fund’s latest forecast is for Australia’s growth rate to accelerate from around 2.4 per cent in 2001 to 3.3 per cent in 2002, while the major and more advanced economies will hardly grow at all.

How will this translate in the financial markets and who will be the winners and losers of 2002?

Merrill Lynch’s Fund Manager Survey, conducted in December, reveals that fund managers worldwide are convinced that the global economy has turned the corner. Earnings growth is expected to recover too. David Bowers, Merrill Lynch chief global investment strategist, says: “Fund managers believe that it is growth in earnings, rather than changes in valuation, that hold the key to the market going forward.”

He adds that collapsing short-term interest rates appear to be restoring investors’ appetite for risk. Forty per cent of those who were polled plan to increase the level of risk in their portfolios. “It’s a trading environment where investors have shorter than usual investment horizons, rather than buy and hold,” he says.

What would fund managers buy? The equity market in the United States remains the market of choice for the next 12 months, but there is also a higher level of interest in emerging markets, and Japan continues to be the least preferred market, according to the survey. The Euro is the currency of choice for the next 12 months, while fund managers appear to loathe the Japanese Yen.

Matthew Drennan, chief economist at Deutsche Asset Management, reckons that a US economic recovery in mid 2002 will tend to favour equities over more defensive assets, such as bonds and listed property trusts. “As investors become more confident of economic recovery, positions will be increasingly unwound in defensive asset classes which offer lower returns in favour of equities. Typically, a large surge in liquidity over and above what’s required for economic growth tends to find its way into equity markets, providing early support for the switch. As the rash of earnings downgrades subside and some better news begins to emerge, this will also favour equity markets. Because the recovery is likely to be modest, interest rates are unlikely to be increased aggressively by central banks. Despite these positives, equity markets are unlikely to return any more than seven or eight per cent over the year ahead, but this should be well above bond returns.”

Jonathan Ramsay, investment consultant at Aon Consulting, anticipates that portfolios will be constructed “that are able to produce robust returns in what could be a long-term environment of subdued returns from traditional equities and bonds. So without making any significant strategic shifts between growth and defensive type investments, the focus on the level of absolute returns within different asset classes will increase significantly and be reflected in the type of mandates awarded”.

He adds: “People are likely to be less reliant on the market to deliver what they want and will look to individual managers to make a meaningful contribution rather than closet indexing, while the performance orientated culture of new asset classes, such as hedge fund-of-funds, starts to look more appealing.”

Equities

Focusing locally, the Australian Bureau of Statistics’ latest quarterly survey of Australian Business Expectations, published in late December, identifies manufacturing and wholesaling as sectors which will benefit from big profit rebounds in 2002, while mining is anticipated to maintain the earnings growth rate of the past year.

The biggest loser is expected to be tourism-related accommodation, cafes and restaurants.

Looking at earnings, Ausbil Dexia believes that the best performing sectors for this year will be infrastructure/utilities (forecast growth: 43 per cent), engineering (35 per cent) and healthcare (31 per cent). The poorest earnings performances are expected in metals (-3 per cent), diversified resources (-1 per cent) and telecommunications (1 per cent).

Xiradis says: “The 2002 financial year should see earnings far more evenly spread, leading to a re-rating of cyclicals and de-rating of premium and defensive stocks … Stocks will be under rotational pressure as earnings recover strongly.”

Ausbil Dexia identifies the positive drivers behind the equity market for this year as housing, declining interest expenses, stable labour costs and consumer spending. In comparison, the major factors driving the equity market in 2001 were interest expenses and the declining local currency.

No major negatives are identified for 2002, with the Australian dollar considered a neutral factor (the negatives in 2001 were labour costs and housing).

Xiradis says: “The issue is the extent to which the equity market can gain from these factors versus the extent to which the positive macro outlook is already priced in.”

For his part, Ramsay detects growing recognition that the ratio of superannuation assets to the amount of publicly listed securities has led to a capacity squeeze for many of the largest Australian equity managers. At the same time, the inherent inefficiency of the small cap universe and the consistent levels of out-performance by most institutional small cap managers has drawn much attention.

“These dynamics will lead to a noticeable trend towards the use of boutique managers with an increasing specialisation between large and small cap companies,” says Ramsay.

He notes, however, that the recent volatility in global equities has the potential to slow the rising increase in allocations to these markets. “The obvious diversification benefits will see this trend continue at perhaps a slower pace, while an increased focus on absolute returns will see increased interest in long/short strategies within a traditional portfolio,” he says.

Ramsay adds that the relative valuation and inefficiency of the small cap universe also has “considerable appeal in this space” and he anticipates “increased demand for specialist global small cap products”.

Morningstar’s asset allocation panel, comprising the financial services industry’s top chief investment officers, finds that Australian shares look likely to maintain their status as an investor safe haven compared with other share markets.

Chair of the panel, Economics New Zealand managing director Donald Curtin says the long-term outlook for shares is brighter with strong economic conditions coming through in a number of countries, including the US.

“The panel’s view is that an increased exposure to international shares is definitely warranted for investors looking for capital growth over the medium-term,” he says.

Bowers believes that investors interested in the equities market should look at basic industries, cyclical services and ultimately resources such as oils. “The strongest sectors in 2002 will be utilities, consumer staples and basic industries.”

Fixed Interest

In the fixed interest market, Drennan believes that the yield curve suggests the global economy is on the cusp of recovery. With longer-term interest rates well above short-term rates, “central banks will be able to comfortably raise interest rates by around the middle of this year, as the recovery takes hold”. But he adds: “As our Reserve Bank Governor, Ian McFarlane quipped in a lighter moment, the yield curve has predicted six of the last two recoveries.”

Ausbil Dexia anticipates that with the large decline in inflation expectations now complete, Australian fixed interest will now struggle to provide the same sort of real returns as in the past decade. “Total returns appear set to be driven more by income. If anything, it is likely capital returns could decline.”

Ramsay argues the relatively narrow universe of largely sovereign fixed interest securities in Australia is sub-optimal and the recent spate of outsourcing arrangements by domestic managers with overseas specialists mirrors that sentiment among fund managers.

He adds that with real sovereign yields around the world at historic lows and credit spreads at historic highs, higher yielding fixed interest securities will receive a great deal of attention. “For larger funds and more diversified structures there are even more exciting possibilities presented by distressed and emerging debt, while hedge funds will also bring their different skill to defensive portfolios,” he says.