Beware of shunning stocks in 2012

by Kate Howitt, Portfolio Manager Australian equities, Fidelity Australia

The Australian economy starts 2012 humming along, 21 years out from its last recession. The Reserve Bank may cut interest rates again to protect growth, after doing so in November and December. Australian companies are in healthy shape and their stocks priced at attractive valuations. If only the global outlook was as bright for equities.

As occurred in 2011, events overseas will hold sway over Australian stocks in 2012. As we start the year, four interconnected global issues are poised to drive Australian (and global) shares in the coming 12 months.

First, it is clear that half-baked solutions to the eurozone debt crisis won’t work. So 2012 will see either a credible push towards European fiscal integration or the dismantling of the single currency. Germany is the key to the fate of the eurozone, where a recession is already underway. A reckoning in Europe – whichever way it goes – will have significant effects on the rest of the world’s economy.

The second issue investors will grapple with is whether the US economy will maintain its positive but feeble momentum. Election-year political gridlock means fiscal policy is unlikely to have much effect on US growth; we are unlikely to see more fiscal stimulus or any of the spending cuts and higher taxes that are needed to fix US government finances over the medium term. If the US economy needs more prodding, it will again have to come from the Federal Reserve. If it acts, the Fed will most likely purchase residential mortgage-backed securities, to lower mortgages for homeowners.

The third issue will be the policy clash in China between reformers, who would like to see a faster rebalancing of the Chinese economy towards consumption by squeezing investment, and provincial authorities, who support reflationary policies. The outcome has obvious implications for China’s demand for raw materials, Australia’s terms of trade and our commodity stocks.

Fourth, the outcome of these situations will be reflected in currency markets. Further US monetary easings via asset purchases would, in isolation, weaken the US dollar. But the threat to the euro reinforces the US dollar’s role as the world’s reserve currency so it’s likely to hold up. For Australia, a stronger US dollar and restrictive Chinese policies would weaken our currency, while significant reflationary moves by the Fed or the People’s Bank of China could see the Australian dollar stay above parity to the greenback for much of the year. That will hamper export and import-competing industries and diminish, in Australian-dollar terms, the 30% to 40% of revenue Australia’s largest companies earn overseas.

The big punt

Since the issues hovering over financial markets are so binary – euro consolidation or break up, US recovery or reflation, Chinese tightening or reflation – it’s no wonder that macro crystal-ball gazing is more error-prone than usual. Amid this uncertainty, what do we know?

Our read of the Reserve Bank is that the central bank remains comfortable with a gradual decline in real residential property values, so property is unlikely to be the stand-out asset class. Given the global macro challenges, it is also hard to see cash returns climbing. So the attraction of bank term deposits is likely to wane.

With fixed income, yield certainty and a limited downside have made bonds a popular haven for investors in recent years. But this popularity is compressing US yields to the point where history shows that capital values are likely to erode from here. And the local bond market is lamentably thin.

That leaves equities. Why would investors want to buy stocks when the world is so grim? Stepping back from the headlines, we see that the Australian stock market offers close to a 5% yield overall, while blue-chip stocks such as the banks, Telstra and real estate investment trusts offer higher income flows. We know that our banks are among the strongest in the world, corporate gearing is at 30-year lows and earnings growth is generally robust.

In 2008, investors experienced the downside of holding equities. Now the stock market offers reasonable valuations, yield support, solid fundamentals and the potential to reflect reflationary policy moves. These factors suggest that at some point in 2012 we may experience something similar to the rebound in 2009. So the biggest gamble of all this year might be not holding equities.