The ASX200 this week finally took out its previous record high set in November 2007, its been a long time in the making but it must be remembered that the Total Return Index (which includes dividends) gained all the ground it lost through the GFC by October 2013. This is important because Aussie companies typically have larger dividend payout ratios relative to international companies, and whilst the price index has taken a long time to return to pre-GFC levels capital has been returned to investors in the form of dividends.
There are a few factors in play, propelling the ASX to fresh record highs, counter intuitively they don’t include a healthy economy and robust corporate earnings outlook. But the ASX200 has defied this dynamic rallying 21% year to date and beneath the surface of the market’s strong performance a “valuation paradox” bubbles. On the one hand, growth, inflation and earnings are all slowing, meanwhile economic growth in China (Australia’s largest trading partner and the global credit engine) is ailing. At an index level, expectations for FY19 earnings growth is lacklustre, FY19 EPS estimates for some sectors of the market have fallen from +9% to just +1%, consistent with the exhausted growth outlook.
The main driver has been central bank policy and a dovish symphony from central banks around the globe. Interest rates in Australia will be lowered again and are set to stay low for an extended period as we heard last week from Governor Lowe, who echoed notoriously dovish central bankers ACB President Mario Draghi and BOJ Governor Kuroda. In this low rate environment, cash is set to yield very little and this tempts savers to climb up the risk spectrum into higher yielding assets.
Lower interest rates also feed into share price valuations. Whereby a lower discount rate increases the present value of future cash flows, justifying higher valuations as interest rates fall, even when economic and earnings growth may be weak thus fueling multiple expansion. Despite sluggish economic growth softening profit outlooks. And that’s why we have seen blue sky growth stocks, like Appen, Afterpay and Wisetech bid up significantly and outperform the broader market.
So, for now, the multiple expansion story is winning out. But, generally collapsing yields and a race to the bottom from global central banks is not a good news story. And the deteriorating growth and lacklustre corporate earnings outlook is largely ignored at current equity prices with the anticipation of central bank support already formidable given the market is pricing a terminal rate of 0.49% by July 2020.
So that leaves little else to propel further multiple expansion without a material uplift in corporate earnings growth. The bar has been lowered sufficiently when it comes to the upcoming August earnings season such that companies should meet expectations. The worry? Currently FY20 EPS estimates are forecasting an uplift from FY19 earnings, so a V-shaped recovery in the outlook for corporate profits, which is optimistic against the current economic backdrop. This leaves a very small margin for error if this in fact becomes a more L shaped recovery, based on subdued outlooks from companies reporting throughout August given economic growth in Australia remains below trend, a manufacturing slowdown drags on global economy, trade war lingers, and Chinese growth slows – meaning that growth is likely to remain tepid at best and there is a myriad of factors weighing on revenue growth. If this sentiment is reflected in company outlooks then this could lead FY20 estimates to be lowered, whilst valuations are already stretched and priced for perfect execution of an earnings uplift and cycle upswing.
What lies beyond taking out this fresh record high is less certain, with the ASX200 having risen 21% year to date and valuations stretched relative to historical averages, the market could be ripe for a retracement.
PE expansion over 1 standard deviation from the average 12-month forward PE is historically unsustainable:
The concern now would be that the next large move for the ASX200 is not a bullish one, given the deterioration in corporate earnings, whilst already a formidable amount of central bank easing is priced. FY19 EPS estimates for some sectors of the market have fallen from +9% to just 1%, consistent with the exhausted growth outlook. You don’t want to be the marginal buyer when valuations are high, and no material growth upswing is visible on the horizon. But once valuations have corrected, the value proposition becomes more attractive as yields are likely to remain low for an extended period, and the dip would likely be bought.
ASX 200 dividend yield premium vs. bond yields at decade highs:
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