2020 Vision

As we enter the last part of 2019, most investors are now looking ahead and asking our thoughts on what the next year could bring. Before we tackle that question, we obviously need to remind you of a famous market saying, as a disclaimer, that “uncertainty is the only constant” when it comes to the future and the financial markets. Unfortunately, that’s just the reality of what we must continue to deal with as we enter another new decade.

To make it simpler, we thought it would be useful to break down the topic into two segments – Domestic equity and the International equity markets. While there are a lot of other very important segments of the financial markets such as bonds and foreign exchange, we will focus on the equity market for simplicity’s sake, as that is typically what our clients have in mind when they think about “the markets.”

The Domestic Equity Market

The Australian market can be broken down into 3 distinct buckets – resources, the financial sector and the remainder.

1. Resources sector (circa 20-25% of the market capitalisation) – Miners are often at their most expensive when their PE (price to earnings) ratio is low. The resource sector is highly cyclical and when they have their strongest earnings, commodity prices tend to also be at their highest. Any decline in the underlying commodity price through a pullback in demand for example, could affect earnings materially.

2. Banking/financial sector (circa 35% of the market capitalisation) – The spate of regulatory and macro-economic headwinds on the banks should continue to pressure the earnings on the banks in the shorter to medium term before they stabilise. However, with rates likely to stay low for some time, banks will struggle to grow earnings as the large capital they must hold earns them almost nothing. While their dividends and franking are still enticing, their share price is unlikely to have any sustainable rise unless they can show a sustained recovery in their earnings. As such, banks are going to be just a yield story going forward.

3. The rest of the market – This is where a lot of the action has been taking place. Much of the PE expansion and earnings growth are taking place within these other sectors of the market. Names like CSL, Cochlear, REA, Resmed and the WAAAX stocks are some of those that have had a tremendous run. However, the Australian market is a very narrow market and the high-quality segment of this bucket also receives the most inflows and therefore the valuation gets more stretched as everyone tries to buy the same names. As such, we are also quite cautious on adding a lot more money into these names as they all trade at a premium (and some at a sky-high premium) to the overall market.

The International Market (Primarily the US)

We can also break down the international segment into three buckets:

1. Dependable single digit earners – These are broadly defined as companies with little disruption risk like Nestle and Pepsico (where substitution and private labels are not affecting materially, unlike Kraft Heinz). Even though the environment for them is still very competitive, the solid companies in this segment can continue forward at mid to high single digit growth rates. They may be trading for around 20-22 times PE but the quality of the companies and the consistency of their earnings growth dominates the equation and therefore investors are willing to give them a higher than average valuation in this low rates era.

2. Solid earnings growth with dependable earnings – Examples include Visa, Microsoft and CME, among others. These companies provide some comfort that even in this low rates, low growth world, there are still strong companies that can deliver double digit earnings growth almost every year. Companies that can deliver in this fashion, if bought at a fair valuation should also see a gradual increase in share price over time as their intrinsic value continues to move higher with their strong cashflow and earnings growth.

3. The frothy part of the market – These tend to be the names that are often on the front pages of the newspaper as they are quite topical and represent new technology companies. Due to these reasons, they are often not profitable but provide an illusion of never-ending growth. Their new technology is considered “sexy” and provides the momentum for traders to jump in. Companies in the “sharing-economy” tend to fall into this bucket. As such, many of them are trading at lofty levels and many of them are not yet making a profit. The recent failure of We Co. to list in the US was a stark reminder of the hey-day of the dot.com era. Should a couple more begin to fail, it could cause a ripple effect on the sentiment of the overall market.

If you wish to discuss any concerns about the current market or about any strategies to do with your financial plans, do not hesitate to call your Financial Adviser.