The long and the short of it

One of the questions we get most in talking to clients is: “why do we have a more positive view on Australian equities than most other global markets?”. This question is usually in response to our 3-year return forecasts that shows indicative returns for Australian equities of around 8% p.a. compared with just 2% p.a. for US equities and similar to lower numbers for core Europe and Japan.

In answering this question we normally preface our response not to get too fixated on the precise numbers, as these really represent a summary of a range of views around long run and short run factors influencing these markets that we have “collapsed” into a return forecast. These factors help give us an idea of the likely quantum of returns across the asset spectrum, the relativity of returns across markets, and importantly risk, but that these numbers tend to imply precision which can be misleading. Over time though, this framework has provided a useful guide and has historically tracked actual outcomes pretty well.

All that said why are our numbers for Australian equities tracking significantly higher than that of the other major global markets?

There are broadly two reasons:

Firstly, our return forecasts are based on a combination of long run (7-10 year) factors overlaid with our cyclical valuation framework. To assess longer run influences we assess all markets using three fundamental factors – yield, long run earnings growth, and structural valuations. On this basis there are two key points of difference. The first is that Australia has a significantly higher yield (more than double that of most other markets). The second is that Australia is closer to longer run fair value, whereas the US market, by contrast, is trading on relatively extended longer run multiples. The clearest example of this is in comparing the CAPE (cyclically adjusted PE) ratios for Australia and the US. Australia is currently trading in line with longer run multiples of around 15 times (consistent with relatively normal future return expectations) whereas the US is trading on multiples closer to 30 times, consistent with very low single digit returns over the medium to longer run.

Secondly, based on our shorter run valuation measures the Australian market is again trading around fair value whereas the US market, for example, is on the expensive side (albeit not ridiculously expensive). Why is this? Well the US equity market has been at the forefront of central bank stimulus for seven years (0% official interest rates, multiple rounds of quantitative easing, and aggressive and persistent central bank “jawboning”). When coupled with reasonable earnings growth this has propelled the US market to extended multiples. However while earnings have been improving they are arguably peak cycle, with the labour market also improving, the currency strengthening and funding costs potentially as good as they get, margins are likely to moderate.

While the Australian equity market is not without its challenges – especially given the extended structural valuations in the financial sector (even after the recent pull back in bank share prices), it has nevertheless underperformed global markets over recent years as declining commodity prices have hit resource and energy producers and associated companies. Arguably though, the market has already significantly discounted the downturn in the commodity cycle – hence valuations look OK – not great, but OK. These views are reflected in the Real Return strategies in a number of ways.

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