The problem with finance and economic analysis is that it mostly relies on history. Their bias is the assumption that nothing is new; that everything will or should, return to a norm. They are ahistorical, in other words. So let’s try something a bit different. Scenarios of the future. We will begin with a report by Deutsche Bank about the Australian stock market. It starts with, unsurprisingly, a historical analogy:
The last couple of months have brought a sense of déjà vu – this time last year markets were also dominated by concerns around European debt, soft US data, and the extent of China’s slowing. We expect these concerns to abate in coming months, which should buoy equities in the second half of 2011. In Australia this could see a rally in resources and banks in particular.
It notes that in the US, employment data (both payrolls and weekly jobless claims) have disappointed, and the ISM dropped sharply. In Europe, there are renewed concerns around the fiscal outlook for the peripherals, especially Greece. Inflation remains high in China, and the PMIs have fallen in the past 2 months. Then it says that while the US has again hit a soft patch, it should be only temporary (return to norm, that is). China, Japan and Europe will also return to norm:
The impact of Japan supply disruptions and poor weather will abate, and a double dip is unlikely given discretionary spending remains low. Private sector job gains have been on a steady uptrend for the past year (ex. May), which we find encouraging. And while the ISM has fallen, it remains consistent with good growth. Strong corporate profitability, a pick-up in corporate loan demand, and very low real interest rates are also positives. Our economists expect that the 23-24 June European Council meeting will endorse a new lending package for Greece, which could calm the market. Spain is by far the biggest peripheral, and an improvement in their public finances and the boost from tourism exports is comforting. Meanwhile, conditions in core Europe, particularly Germany, are solid. While inflation in China remains high, the recent trend in daily agricultural prices points to some moderation in coming months. And while the PMIs are down, they remain above 50 and thus point to solid growth. Further, the OECD’s leading indicator points to solid growth continuing in coming months.
These “return to norm” scenarios are always the safest for analysts. Thus we get this for the Australian market:
The Australian equity market has seen very limited sector divergence this year, as is common in soft markets. If the global environment improves, the market should move higher, benefiting at least some sectors. Better risk sentiment could see commodities head higher (as in 2H10), buoying resource stocks. Banks look cheap and have limited near-term downgrade risk. Across the rest of the market, cyclicals have been weak but don’t look overly attractive – earnings downgrades have limited PE de-rating, and further downgrades could be in store as the high AUD persists. Valuations for defensives look reasonable, given they inherently have less downgrade risk. In sum, we retain our portfolio strategy of O/W resources, banks, resource capex plays, food retailing and utilities.
So far, so predictable. The report then goes on to look at which sectors are cheap (figures 23-33), concluding that only building materials, packaging and contractors are expensive by long term historical norms. Mining looks cheapest on 12 month forward earnings multiples.
So let’s have a little experiment, one in which I hope you participate. Three scenarios for the ASX: bear, muddling through, bull.
Scenario 1. Bear.
Over the next year, the Chinese economy starts to experience something it has not had for over two decades: a business cycle. Iron ore prices fall sharply, causing a widespread correction in the Australian resources sector. The complacency in Australia is shattered, which contributes to what is already a rapidly weakening housing sector. The All Ords has a major correction, hit by the twin effects of less valuable holes, and less valuable houses. The banks start to get into serious trouble, and require the re-establishment of government guarantees. The Australian dollar gets weaker as the trade weighted index falls, but still remains high because it is seen as an energy play because of Australia’s massive LNG reserves, coal and uranium. So there is only a mildly relieving effect for an already battered manufacturing and services sector. The Reserve Bank drops rates, leaving investors with few decent choices for decent returns. Perhaps the best plays are cash, gold miners and emerging markets (which is both a growth and currency play, but which is also a complex investment option). The US economy goes into a double dip recession, greatly increasing the need for a war to re-establish spending and increase employment (soldiers). It is the beginning of the death throes of the hegemony of the American empire. Likelihood: 20-30%.
Scenario 2: Muddle
The global economy experiences moderate growth rates and China continues to power on at 9-11%. Commodity prices are reasonably stable and because the value of mining stocks is mostly priced in capital gains are just alright. Energy and food prices continue to strengthen, rewarding Australian investors in those few stocks that are available on the ASX. Investors who look at overseas energy and food options do OK, but the strong currency trims returns. The US economy has low growth, and Europe bumps along the bottom but manages to keep the Euro zone together by finding ways to help smaller countries default without imperilling the banks (debt for equity swaps are the preferred method). The All Ords goes mostly sideways, putting an emphasis on high dividend paying stocks: Telstra turns out to be the surprise performer. The housing market eases slightly, causing the banks to be under performers and further denting consumer sentiment. The Australian dollar stays high, meaning that manufacturing and exports are subdued outside primary resources. Interest rates go nowhere, and Australia starts to get used to a low growth Eastern seaboard and a high growth resources and energy sector. High tax revenue from resources keeps the government in a strong fiscal position, but the Australian economy starts to be permanently skewed away from secondary and tertiary industry. Only companies that start to successfully globalise, or which have strong domestic market shares, have good strategic options. The best plays are defensive stocks, good global companies, resources and energy, emerging companies and local cartels that pay strong dividends. Banks and retail struggle. Likelihood: 50-60%.
Scenario 3: Bull.
China’s strength continues and it starts to aggressively open up its financial markets. This begins the unleashing of capital as China looks to ensure security of supply in raw materials and energy. This electrifies the resources sector of the Australian market. China struggles to get control of local companies but the mere presence of Chinese buying pushes up valuations. China also starts listing companies in Australia to find new avenues for capital. The Australian dollar hits new highs, harming manufacturers and services exporters, but the Australian government, which has strong tax revenues from the mining boom starts to look at ways to support the old economy through direct support. On strong income growth, Australian houses flatten out and even inflate a little, relieving pressure on the banks and retail. Interest rates rise and savings remain strong but not enough to choke the services sector. The long awaited boom in life sciences stocks starts to materialise, helping offset some of the weakness in retail and banking. Investor sentiment and fear start to decrease, in part due to a better than expected recovery in the US, which leads to stronger earnings multiples on the ASX. Perhaps the best plays are: resources, life sciences, construction, wealth managers, food retail. Emerging markets may also be good, but there is likely to be a negative currency effect. Likelihood: 15-25%.
OK, see what you think. I’m a bear, myself.