Two speeds not priced in

A report by Deutsche Bank today suggests that the two speed economy may not be being effectively priced in. The comparing with last financial year means it is not a long term comparison so of limited utility, but it may point to institutional trading strategies in the shorter term.

Compared to their FY11 average, the resource sector PE is currently at an 8% discount, banks at 11%, but industrials are only at a 6% discount. We think this is unjustified, as industrials have had a worse track record of earnings downgrades over the past year or two. Both FY10 and FY11 had been expected to deliver low teens eps growth for industrials, only to be revised down to essentially no growth.

The Deutsche report is, unsurprisingly, predicting downgrades with industrials, which is hardly a surprise:

Industrials likely to see downgrades to FY12F earnings

Consensus expects industrials EPS growth of 17% in FY12. We see this as (at least partly) a ‘default’ forecast. Earnings recoveries typically follow downturns, and as earnings have not grown in 3 years, analysts have assumed a recovery for

FY12. But with a range of headwinds remaining, and potentially intensifying, a recovery may remain elusive. Thus, the risk is that companies deliver cautious commentary in August reporting and that analysts pare back FY12F earnings.

A range of headwinds ahead for industrials

• Overall consumer sentiment has fallen to below-average levels. More concerning is the ongoing slide of households’ perceptions of their own finances, to reach recessionary levels.

• While much discussed, engineering construction has only recently begun to ramp up. Given a record pipeline of work, activity is set to accelerate in FY12 and FY13, potentially crowding out other sectors.

• With inflation around average at present, stronger capex is likely to raise upside risks, keeping the RBA with a tightening bias.

• If rate markets begin to price RBA hikes rather than cuts, the AUD could see upside from already high levels. This would squeeze not only USD-exposed

stocks, but have second-round effects on domestic cyclicals.

It’s all pretty much statements of the obvious, with the implication that the market is going to be increasingly skewed to resources. Hard to argue with that:

Resources earnings growth to continue. O/W resources, U/W industrials. Resources have delivered solid earnings growth, and the past week has brought signs of Chinese inflation peaking, and growth holding up. FX and commodity markets seem to be priced for good growth in China, and equities should begin to catch up. We stay O/W resources, O/W banks and U/W industrials (and amongst industrials, we favour resource capex plays and defensives – WOR, NWH, TSE, ABC, WOW, AGK, AMC, WES).

The question, as always, is how much has the obvious been priced in? This report implies that the pricing of industrials may be a little off, but that does not necessarily mean it is accurate with resources stocks. It is very much a case of individual stock picking rather than more general allocations.

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  1. Sandgroper Sceptic

    Overweight resources is understandable if you are a China bull. But if you are bearish then resources look toppy.

    Still overweight banks? Come on guys, banks will be in trouble with your identified themes in play, it will of course show up with a slight lag but that is why you should be exiting your O/W banks call now.

    I would also dispute whether Wesfarmers and Woolies are true defensives, I expect they will suffer too. Wesfarmers is very vulnerable if weakness shows up in Bunnings, and growth there has been slowing and Woolies move into the same space will prove an expensive mistake. Their other retail operations like Big W must be struggling, perhaps not as bad as David Jones but nominal sales growth is probably flat to down in non food areas and even food will be hurt as the recession starts to bite. I would not be piling into those stocks just yet.