Australia

Paul Taylor, Head of Australian Equities at Fidelity Worldwide Investment and Portfolio Manager of the Fidelity Australian Equities Fund - December 2011

“Banking crises are generally followed by sovereign debt crises and these tend to be followed by increasing inflation.

“The events in Europe are part of this bigger cycle. It’s not the end of the world, but you have to be aware of what it means - for the local market, local companies and local investors. One thing that the latest gyrations in Europe will definitely lead to is slower global growth and a prolonged recovery period. This will impact our currency, exporters, consumer demand and more.

“Despite this, there are still pockets of good growth in the local economy and market, with several companies remaining in good shape and growing well – and not valued as such.

“We’re in a very different environment to that of the original global financial crisis (GFC), which was all about debt on corporate balance sheets. Through the GFC Australian companies repaired their balance sheets and are now in a much better position. Though some strengthened more than others. Investors need to take a back to basics approach and seek good companies with good cash flow. Investors need to find the structural growth opportunities, find which companies are growing faster, which companies have really good industry positions and the best growth opportunities.

“Besides looking for companies that are continuing to grow I am also looking for those that are providing income. Stocks that can provide both growth and yield will be bid up by the market. There are several listed companies that are paying dividend yields that are well above that of bank term deposit rates and these will increasingly be in demand from investors seeking consistent income from the market.

“What investors should try to do, what I am trying to do, is to withdraw the macro influences from a portfolio as much as possible. You can only do this by taking a bottom-up stock picking approach.”

Kate Howitt, Portfolio Manager Australian Equities– December 2011

 “There are four issues that will drive markets in 2012. One of the main factors to include markets in 2012 is that it will become clear that ‘halfway house’ solutions for the Euro won’t work, so 2012 will either see a push towards European fiscal integration, or the dismantling of the single currency in its current state. Germany must decide on the fate of the eurozone – and this will have significant impacts for the rest of the global economy.

“A second factor is that markets will grapple with the ability of the US to maintain its current slight positive economic momentum. US election-year inertia means fiscal policy is unlikely to be a factor, either in stimulating the economy or in implementing the cuts required to by the extension of the debt ceiling. If the US economy needs further stimulus it will again have to come from the Fed, most likely this time in the guise of asset purchases of residential mortgage backed securities in an attempt to provide relief to homeowners via lower mortgage rates.

“A third factor will be the outcome of the current policy debate in China between reformers who would like to see a faster rebalancing of the Chinese economy towards consumption by continuing the squeeze on investment, and the provincial authorities who are supportive of reflationary policy moves.

“The outcome here has obvious implications for China’s demand for raw materials and hence Australia’s terms of trade, commodity stocks as well as domestic interest rates. We know that the Reserve Bank of Australia (RBA) will be responsive to any weakening in the economic outlook for Australia, but it also seems clear that it doesn’t want to see house prices grow to any meaningful extent in the interest of restraining household debt levels and so it will remain vigilant to any signs of housing market exuberance.

“Fourth, the net outcome of these situations will be seen in the currency markets. A stronger US$, ongoing restrictive Chinese policies and lower RBA cash rates would weaken the A$; while reflationary moves by either the Fed or the Chinese authorities could easily see the A$ sustained back above parity for much of the year.”
These factors would have different impacts on different asset classes over 2012.

“The RBA appears to remain comfortable with flat nominal house prices. So property is unlikely to be the stand-out asset class.

“Given the macro uncertainties it is also hard to see cash returns trend up in the next 12 months, with bank deposit rates already dropping recently. Accordingly, cash may no longer be king and its attraction is likely to weaken.

“That leaves us with equities. But, why would you possibly want to buy equities when the world is so grim? Stepping back from the headlines, we know that the local equity market is offering close to a 5% dividend yield - with even higher yields from selected blue chip stocks such as the banks, Telstra and REITs. We know that our banks are some of the strongest in the world, corporate gearing is at 30 year lows and earnings are generally below cycle-peaks, with the market offering reasonable valuations, yield support, solid fundamentals and the potential for reflationary policy moves.

“These factors suggest it may not be too long until we are back to 2009 where there was a greater risk to not holding equities. Markets tend to ‘climb the wall of worry’. So even though Europe is unlikely to be ‘solved’ in any quick way, an end to the uncertainty would likely give rise to a relief rally.”

Paul Taylor, Head of Australian Equities and Portfolio Manager of the Fidelity Australian Equities Fund - August 2011

“Markets are nervous, sceptical, cautious and scared and for very good reasons. We have a European sovereign debt crisis, a huge US debt issue, worrying US economic growth, slowing global growth and concerns that China may reign in growth too hard and go straight past the soft landing scenario and head directly into a hard landing. Further depressing the market is the thought that the sovereign debt issues in Europe and the US are likely to be with us for a prolonged period of time – major readjustments like these take a long time to play out.

Having made all those depressing comments any potential bright spots or glimmers of hope tend to get drowned in the over riding gloom of the current market sentiment. There is some good news in the US reporting season which is generally better than expected on both revenues and costs and I believe that China is much better positioned than market fears would suggest. The simple fact that Chinese policy is trying to lower growth to a more sustainable level and control inflation already means that they are in a stronger position than the rest of the world which is struggling to achieve any growth. The worse the rest of the world gets the higher the likelihood that China will at least halt its monetary tightening policy. China demonstrated through the global financial crisis (GFC) that it will act very counter cyclically and step up and invest when the rest of the world is struggling and they may well take the same approach again as global growth slows.

What does all this mean for Australia? It means that with the sovereign debt issues in Europe and the US we are in a lower growth world. As the world undertakes de-leveraging this will have a negative impact on global growth and Australia as a small open economy will be negatively impacted by lower world growth.

However while we are in a lower growth world this does not mean everything is low growth, it means on average we are low growth but within this average we will see some real pockets of growth. These pockets of growth will include China and a range of emerging economies. Australia will continue to be a beneficiary of its complementary economy with other emerging economies like China.

With investors so cautious and sceptical they are implying that not only are we in a low growth world but that every market and every company is low growth – and that is the real opportunity in the market at the moment.

We have seen very significant compression of valuations between markets as well as stocks within markets as investors become very sceptical about growth for all markets and companies. The Australian market is currently very attractively valued at about 10-11x price to earnings ratio and a 5% dividend yield. This sort of valuation is very attractive from an absolute perspective as well as relative to Australia’s own history. The Australian market has historically traded at between 14-15x price to earnings ratio. It is hard to see the Australian market re-rating from 10-11x back to 14x-15x over the next 12 months while these macro black clouds remain, so the market’s performance will likely come from the market’s earnings growth and dividend
yield. It is very realistic to expect Australian market returns of 10%-15% over the next 12 months from dividends and earnings growth even without a valuation uplift.

I think the really interesting point over the next 12 months will be the differentiation at the individual stock level. The pockets of growth in the market will provide a real opportunity to differentiate those stocks with significant growth opportunities. In a low growth world those stocks with growth opportunities will likely be bid up by the market as they become rare assets.

As valuations are compressed the market is not differentiating between those companies with growth and those without growth. When we look back through history these sort of periods prove to be great long-term investment opportunities into great quality companies, with strong balance sheets and management teams, excellent growth opportunities and attractive valuations.”

This document is issued by FIL Responsible Entity (Australia) Limited ABN 33 148 059 009, AFSL No. 409340 (“Fidelity Australia”). Fidelity Australia is a member of the FIL Limited group of companies commonly known as Fidelity Worldwide Investment. Prior to making an investment decision, retail investors should seek advice from their financial advisers. Investors should also obtain and consider the Product Disclosure Statements (“PDS”) for any Fidelity fund mentioned in this document. The PDS is available at www.fidelity.com.au. This document may include general commentary on market activity, sector trends or other broad-based economic or political conditions that should not be taken as investment advice. Information stated herein about specific securities is subject to change. Any reference to specific securities should not be taken as a recommendation to buy, sell or hold these securities. While the information contained in this document has been prepared with reasonable care, no responsibility or liability is accepted for any errors or omissions or misstatements however caused. The document may not be reproduced or transmitted without prior written permission of Fidelity Australia.
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