Setting the stage for 2009

After a difficult 2008, investors might be uncertain what to do this year. Matthew Sherwood, Perpetual’s Senior Manager, Investment Markets Research provides an outlook for 2009.

2008: The backdrop

2008 was a particularly difficult year for investors, with the negative effects of the credit crisis becoming clear. We saw huge swings in both domestic and global markets and the collapse of large corporations such as Bear Stearns and Lehman Brothers. By the December quarter the Australian sharemarket had delivered five consecutive quarterly declines and closed the year down 40% – the lowest calendar year return since the sharemarket began in 1876.

The drastic sharemarket falls were the result of the combination of three factors:

• The credit crisis. The global credit crisis resulted in firms’ cost of capital increasing, prompting a large amount of equity capital raisings which diluted earnings per share.
• The economic outlook and investor sentiment. The credit crunch resulted in a global economic recession and this led to earnings growth turning sharply negative as consumers deleveraged and corporations cut back on investment spending.
• Market valuations. The excessive market valuations we saw at the end of 2007 dissolved as investor optimism quickly faded.

2009: A repeat performance?

What will happen in Australian and global sharemarkets depends on the developments of the three factors that underpinned 2008’s downward trend.

Credit markets – beginning to thaw

Strains in global credit markets escalated in September 2008 following the collapse of Lehman Brothers. Reduced trust between financial institutions and higher lending rates between banks led to a vast leap in the difference in the expected risk-free interest rate (the swap rate) and the interest rate at which banks lend to each other (the libor rate). The two rates are usually very similar (see Chart 1), but at one stage US banks were charging an additional 3.5% to borrow funds from another institution. This higher premium raised banks’ funding costs and, by association, business and housing interest rates.

But recently, reductions in official interest rates and guarantees by many national governments in relation to bank funding have resulted in these spreads declining markedly. Even though there is still a way to go in this process, it suggests that the thawing of credit markets in relation to bank funding has begun, which is a necessary, but not sufficient, condition for any sharemarket recovery.

Economic outlook

There is little doubt that the first half of 2009 will be one of the most challenging times for the Australian economy over the past three decades. There will be many players: factors that support the economy and factors that have the opposite effect.

Rising stars:

Falling stars:

Market valuations

The relatively high valuation of the Australian sharemarket has dissipated. In particular, the decline in the Australian sharemarket since November 2007 has resulted in a continued decline in the trailing P/E ratio, which is based on recorded earnings for the past year, to its lowest level since the 1982/83 recession. In a similar way, the forward P/E ratio, which is based on the market’s expectation of earnings for the upcoming 12 months, has experienced a sizable decline to its lowest point since the 1991/92 recession (see Chart 2).

Star attractions – security and income

In the current climate many investors are tempted by the apparent security of cash. If we examine the recent performance of cash it can be seen that it has had a higher short-term return relative to shares, has never posted a negative return and passes the ‘sleep well at night’ test. And history demonstrates that on occasions cash does indeed post higher five year returns than shares (such as in the mid-1970s and early 1990s – see Chart 3), however deeper analysis reveals two important points.

Firstly, the outperformance of cash is not sustained, with the Australian sharemarket recording higher five year returns on around 80% of occasions since 1955.

Secondly, the high double-digit returns of Australian shares in the ‘good years’ more than compensate investors for the occasional hard year like 2008. This is shown by the value of an investment over the long term. For example, an investment of $100 in Australian cash in 1955 (earliest available data) returned an average 7.9% per annum (or 2.8% pa in real terms) and would be worth $6,165 at the end of 2008. In comparison, the same investment in Australian shares returned 12% per annum (6.9% pa after inflation) to be worth $46,730 by December 2008, even though the market declined by more than 20% in five of the years.

Income generators – shares versus cash

Although shares have higher long-term returns, investors may be considering which asset will deliver higher cashflow in the current environment. The Reserve Bank of Australia (RBA) continues to lower official interest rates and returns in the declining cash market, but firms are also likely to cut dividends in the prevailing economic climate. The question that springs to mind is ‘what dividend yield is equivalent to this cash market return’?

On 3 February, the RBA cut official interest rates to 3.25%. If they remain at this level (which is significantly higher than market expectations), the breakeven analysis for Australian dividends (adjusted for franking credits) is around 2.5%. This would require a cut of around 60% to bring current dividends down to this level, while higher yielding industrial shares would need a cut of 70%. This reduction is more than occurred during the Great Depression (when dividends declined by 55%). This suggests that from a cashflow perspective Australian shares offer more potential for income over the long term than the domestic cash market.

Implications for investors – a focus on ‘quality’ stocks

Economic growth will be weak for much of 2009, which will negatively impact company earnings, but this has already been factored into sharemarket prices. On the positive side, valuations have declined and interbank credit market conditions have begun to improve. But are prices at an appropriate level for the impending environment? Should they be higher or lower? Only time will tell.

In 2009, companies are susceptible to both earnings risk and balance sheet risk. Stocks with strong ‘cashed-up’ balance sheets and high levels of earnings certainty are likely to find favour with investors and provide protection in the event of more market volatility. These stocks are in the best position to grow their business organically, deliver sustained dividend growth to investors in the years ahead and are likely to lead any recovery. The key for investors is determining which stocks have reasonable earnings outlooks and strong balance sheets and, yet despite this ‘quality’, have been oversold.