Australian sharemarket at risk of being hit by offshore concerns

The Australian sharemarket will be dragged down if offshore markets succumb to economic worries as coronavirus cases around the world explode.

US political uncertainty and the arrival of a second wave of COVID-19 has pushed equity volatility higher, an analysts argues. Picture: AFP

The recent outperformance of Australian shares should continue due to the nation’s vastly better trends in coronavirus numbers, its world-leading fiscal stimulus and expectations that the Reserve Bank will cut rates and expand its asset-buying at next week’s meeting.

But the local bourse will be dragged down if offshore markets succumb to economic worries as coronavirus cases explode and much-needed US fiscal stimulus remains in limbo before the November 3 election.

The resources sector may be a weak link in the short term as oil prices start to suffer another bout of demand jitters, iron ore prices ease after a recent run-up in China’s iron ore port inventory, and coking coal prices continue to tumble in the wake of China’s ­import restrictions on Australian coal.

But while global sharemarkets have recently warmed to the prospect of a clean sweep by Democrats in the US election, OANDA’s Jeffrey Halley says the “wolves of Wall Street” would ­arguably prefer a Biden presidency and a Republican Senate as that would “be the best of both worlds” — allowing simultaneous repair of America’s international relations while reining in Democrat profligacy.

And with markets priced for a “blue-wave” victory and massive US stimulus deal, in the short term at least, a Democrat minority in the Senate would cause “speed bumps in the ‘buy everything’ trade”.

“Given the possible permutations over the US elections, let alone stimulus negotiations, a lot must go right for that to happen,” Halley says.

“History teaches us that life is not so linear and predictable. Therefore, I continue to believe that reality will strike home this week, and a reduction in risk positioning will characterise it.”

To complicate matters, some strategists — such as Morgan Stanley’s Michael Wilson — believe the betting market’s most-favoured outcome (a Democrat sweep) would be negative for equities, even though the market has shown no real concern about that in recent weeks.

Not surprisingly, Wilson sees only 2.5 per cent upside potential and 11 per cent downside potential for the S&P 500 from Friday’s closing level of 3465.4.

He notes that US political uncertainty is “holding up the next round of fiscal stimulus” and, together with the arrival of the second wave of COVID-19, has pushed equity volatility higher.

While it was only 3.6 per cent away from record highs, the S&P 500 is losing momentum and has not set a record close in eight weeks, the longest period since the new bull market began in March.

Wilson argues that with so much uncertainty surrounding the US election outcome, the second wave of COVID-19, and upward pressure on long-term interest rates and volatility, the equity risk premium should be about 10 per cent higher — implying the index should be 10 per cent lower.

But with the revaluation of equities largely over at this point, he says investors should favour companies that can deliver higher earnings growth than what’s already priced in.

“While many seem to favour companies that have been able to operate normally during this pandemic and take share, this may not be the best investment strategy from here,” Wilson says.

“Essential businesses/services or digital transformation enablers have been spectacular performers this year, but this just means that expectations are high and comparisons difficult.

“Furthermore, there is likely to be some payback on demand and loss of wallet share next year for such companies. In contrast, businesses and services that have not been able to operate normally may provide better investments at this time primarily because expectations remain low and wallet share gains are likely.”

Of course, investors need to be selective because many of these companies that are not able to operate normally today may never recover, at least not fully.

Similarly, Citi’s Tobias Levkovich is cautious because sentiment is bullish and valuations are high. “Euphoria readings, while lower than in late August, continue to imply downside risk and our P/E bull’s eye also suggests poor returns,” he says.

With a variety of valuation metrics at the upper end of historical ranges, it’s “challenging to discern ‘attractive’ levels”, though his normalised earnings yield gap work remains upbeat.

A sharp recovery in EPS trends for the second half of 2020 and next year and the heavier market capitalisation weight of secular growth constituents versus history justifies “a good chunk of recent index level appreciation” and he sees further modest profit gains in 2022 as well.

But Levkovich warns that such a rebound in earnings per share may be reflected in market pricing already, with plausibly higher corporate tax rates (and capital gains and high-income earner tax rates) restraining upside potential.

Similarly, credit conditions argue for a mid-2021 durable economic turn, but that’s eight months away and share prices have rebounded sharply in anticipation.

He sees commercial and industrial lending standards improving from very tight levels reported in August, supporting a more resilient recovery from the third quarter of 2021, by which time broadbased coronavirus vaccination may be occurring. But with household equity exposure near 50-year highs as a percentage of financial assets, he says it’s not clear who the incremental buyers are for stocks.

“With buybacks down and significant retail investor ownership of stocks, plus large foreign holdings that could ease in the case of a weaker dollar, identifying the new purchaser is difficult,” Levkovich says. “Arguably, M&A could step up in a cheap financing environment, but it is unclear if that would be enough, particularly as many deals are being done using equity versus cash.”

He has a year-end target of 3300 points for the S&P 500 and 3600 for mid-2021, but says the bigger issue of value versus growth for portfolio positioning reigns as the most crucial one for fund managers.

“Many see low rates for the distant future sustaining the secular growth names and their valuations,” he says. “Others perceive an inflection point next year for a variety of reasons including the lapping of coronavirus-related comparisons by 2Q21 and we suspect the latter group is on the right track even if the shift looks to be more skewed to January as opposed to the current quarter.”