Some very smart pundits like to say that stock markets don’t discount recoveries, they create them. As the ASX rushes higher is that in prospect for Australia?
In some ways, yes. The rally is already spreading a wealth effect, playing some kind of a role in lifting the spirits of consumers as super balances swell for the first time on four years. Next up there is sure to be a rally in the top-end of the property market which has a high correlation with share market returns, as the AFR explores today:
Volumes and buyer interest at the top end of the property market are starting to move, as the sharemarket rallies and interest rates remain at historical lows.
The S&P/ASX 200 surged through the 5000 point barrier last week and observers are expecting a kick in the prestige property market, particularly on Australia’s east coast, as it is highly correlated with the sharemarket.
This is partly due to the residential market’s dependence on the bonuses generated in the financial services industry and also because of the sharemarket being a barometer of confidence.
To the extent that upper-end property has an out-sized impact upon house price indexes, the recovery such as it is will lend more confidence to the wider housing market as well.
Through the first half of this year this could erode the rock solid post-GFC national savings rate that has been evident since 2008 and boost retail sales at the margin. I do not expect a sudden collapse in savings. But even a small shift will be felt in activity.
Perhaps this might also lead to a small uptick in investment in consumer facing sectors but that will take time and with such a high dollar remains doubtful.
And therein lies the problem. We know that an end to the mining investment boom is nigh. The RBA sees it happening right now. Most private forecasters, including me, see it mid year. A few at the end of the year. Estimates vary too on the pace of the decline but all see it weighing heavily on growth, especially nominal growth as the terms of trade boom bleeds away as well.
The battle, then, for the stock market is whether it can hold its soaring valuations in the face of mediocre earnings growth. If the Australian economy can rebound to nominal growth of 5% and real growth of 2.5% for the next twelve months (which is more than fair!) then where will that leave stocks? As a bourse, how is the ASX going to grow faster than nominal GDP?
Here are the key valuation metrics for the ASX200 at yesterday’s close (not that valuations are driving the rally but it gives us a benchmark):
So, we’re now trading on forward price/earnings ratio of 20. That’s the richest mid-cycle valuation in living memory:
It says a lot that at no time during the 2003-2007 bull market did valuations get this stretched. Indeed, the only times forward price/earnings have been higher is during recession conditions when the bourse is discounting a recovery amid wholesale write-offs.
You might argue with some justification that we’re not mid-cycle, given late last year much of the world was in recession. For Australia, much of the economy has been stalled or in recession as well to make way for mining and adjust its external debt. Is this not just another reflation rally?
Perhaps. But such analysis is born of past cycles of monetarist booms and Keynesian recoveries. This time Australia is only part way into a structural adjustment that restricts economic growth largely to internal funding even as mining investment winds down. To the extent that the share market rally causes a fall in the savings rate it may exacerbate the funding challenge. With these restrictions, current estimates for aggregate earnings growth of 25% or more over the next two years are, in a word, delusional.
That means that even accounting for some extra premium born of financial repression, the bourse is already looking very rich.
That is not to say that it’s all about to end. We’re clearly twirling towards freedom on the benefits of financial repression. I expect as the year gets older and mining investment weakens that the pressure on shares will increase. But this will be offset by upward pressure on valuations from rate cuts and a falling dollar.
Can the bourse carry the economy alone? It’s a lot to ask.