Can cost-out save the ASX?

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Deutsche thinks so:

FY14 marked a return to earnings growth for Australia, following two dismal years. But there is concern that much of the growth was driven by efficiency programs (6% EPS growth on 3% sales growth), which aren’t a sustainable driver of earnings. And with little sign of a top-line acceleration, the fear is the earnings recovery could fizzle out.

The experience of the US suggests that efficiency programs can support earnings for some years. US firms have generated solid EPS growth (9%) from only modest sales growth (5%) for almost 4 years now. Inefficiencies can creep in when the macro environment is strong (as in 2003-07) and when there aren’t big downturns that prompt companies to look at self-help measures. So with Australia having a bigger boom and shallower downturn than the US, there may be at least as much work to do here.

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A couple more years of efficiency programs bearing fruit should buy time for the top-line to return. Sales growth tends to be linked to nominal GDP growth, which looks set to pick up a little, and analysts do forecast better sales growth. As with all forecasts, there is obvious downside risk. But top-line forecasts to tend to be more reliable than EPS forecasts.

Equities are back to the average of PE of ~14x. But we don’t view the average PE as being appropriate given persistently low bond yields. Soft data in Europe (both growth and inflation) prompt DB economists to expect ‘public’ QE, as the Fed has done. This could continue for some time, given the ECB has let its balance sheet shrink, keeping the ‘shadow’ policy rate (a single measure that incorporates conventional and unconventional policy) almost 300bps higher than the Fed. ECB action could keep US yields lower for longer also – already US bonds have largely ignored the stronger domestic data, instead focusing on offshore developments.

That’s one of the more sophisticated bullish arguments I’ve seen in recent times and is more than fair. A couple of points to add:

  • US firms are typically much more aggressive at cost-out that Australian firms so we’re likely to adjust commensurately slower. This is obvious across the board in union power, a kurzarbeit labour market, stronger government suppports and the simple culture of the place;
  • the US adjustment was front-end loaded with a massive wealth loss in households and corporates didn’t waste the crisis. Australia faces a grinding adjustment over many years (assuming housing doesn’t crash) which will mean no obvious trigger for mass cost cuts and nominal economic growth is in for a long and low grind as the terms of trade keep falling for years;
  • the structure of the Australian economy is more narrow than that of the US. We are more services dependent and cost-out is more difficult in these sectors where there is little mechanisation.
  • the Australian economy and its corporations are very income-growth dependent so cost-out tends to impact the top line more than it does in US firms.

These arguments are not to say that the Deutsche thesis doesn’t hold water. It does. Cost-out is the future for the Australia economy. The point is that barring crisis, when earnings get crushed anyway, the process is likely to be slower than in the US, and therefore less supportive to ASX earnings.

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I reckon an ongoing global de-rating is much more likely with PEs relative to global bourses likely to return to pre-boom discounts. From UBS:

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About the author
David Llewellyn-Smith is Chief Strategist at the MB Fund and MB Super. David is the founding publisher and editor of MacroBusiness and was the founding publisher and global economy editor of The Diplomat, the Asia Pacific’s leading geo-politics and economics portal. He is also a former gold trader and economic commentator at The Sydney Morning Herald, The Age, the ABC and Business Spectator. He is the co-author of The Great Crash of 2008 with Ross Garnaut and was the editor of the second Garnaut Climate Change Review.