Although we are now recommending clients lock in some gains on international shares, globally Credit Suisse believes investors should hold a higher than average allocation to Australian equities. We have been buying Australian equities since the beginning of April but still see upside. That said the next month or two may see some weakness, so those looking to add should get the opportunity.

Based on consensus expectations, financial year 2020 earnings are expected to decline by 20%, approximating what occurred during the GFC. A lot of bad news has been factored in. But like the GFC, earnings are expected to recover - by 8% in 2021 and 13% in 2022.

ASX 200 Earnings Index – Based on Consensus

Source: Credit Suisse, Data Stream

Not only are earnings expected to recover, but there is evidence that earnings upgrades are starting to filter through, as companies gain confidence in forecasting future earnings and economic data is not as bad as previously feared. The retail sector has been surprisingly strong as consumers spend superannuation withdrawals, receive government support and buy the infrastructure to enable work from home. The large miners are due upgrades based on spot iron ore prices. Energy producers should also see upgrades based on the current oil price. Even the banks appear to at least be meeting expectations as bad debts are contained so far. We believe economic and earnings data will continue to improve as the economy opens up. Australia’s sterling effort in controlling the virus, leverage to China which is essentially back to work, and massive fiscal and monetary support, should continue to see an improved earnings outlook.

But, Australian equities have already recovered nicely. The ASX 200 has risen 31% since its March low. Capital gains have occurred against the backdrop of earnings per share (EPS) downgrades, such that the market's price-to-earnings (PE) multiple on a 12-month forward consensus basis has risen disproportionately to almost 19x. Investors have now started to question whether the market has become too overbought, if not too expensive. To be sure the easy gains have been made, but the rise in PE is very similar to the GFC experience as the recovery got underway. PE’s early in an earnings recovery should be high. Admittedly the PE is higher than the recovery phase of the GFC, but very low interest rates do justify a higher PE going forward, as the discount rate applied to future profits is reduced. Historically, PE falls with earnings recovery rather than a decline in share prices.

Australian Equities PE 12 Month Forward

Source: Credit Suisse, Data Stream

Apart from showing some absolute upside in the medium term, we also think Australian shares look attractive relative to international shares. Below is a graph of an index we created to track relative valuation of Australian equities versus international. It takes an average of PE, price to book and dividend yield and compares it to the rest of the world.

Relative Valuation – Australian Equities Versus International

Source: Credit Suisse, Data Stream

The index shows Aussie shares are trading almost two standard deviations cheaper than normal relative to international shares. The last time Australian shares looked so relatively cheap, at the beginning of 2016, they outperformed for six months, led by the miners.

The miners look well positioned to us and our discretionary portfolios hold an overweight position in the big three iron ore producers. We have also been slowly adding to our banks exposure due to attractive comparative valuation on a historical basis, and the view that a very poor scenario has been priced in that won’t eventuate. RBA action to anchor medium term rates at a low 0.25% has seen the yield curve steepen which should support loan margins. We have a core of quality growth stocks in the Healthcare sector and are underweight A Reits, and in particular retail mall owners which face structural and cyclical headwinds pre and post Covid-19.

As always, there are risks to our view. A poorer than expected outcome as to Covid-19 cases and reintroduction of restrictions may see markets leveraged to global growth like Australia sell off sharply. Fiscal policy is due to run out in September, creating a cash cliff for households. We think the risk of this can be managed as the Federal Government has shown a willingness to introduce or extend programs. The US election is four months away and announcements from the two candidates could see weakness. Overarching these risks are central banks taking a “whatever it takes” approach to support the recovery.

At every point in time markets have risk, but for the moment the positives outweigh the negatives for Australian equities. 

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Robert Delforce

Great thought-provoking article, Andrew - cheers. To an old economist realist a couple of points though: 1. Australian shares being "two standard deviations cheaper than international shares" being a trigger to buy Australian shares is not prudent if both are fundamentally expensive going forward - If SO, this statistical observation merely means that buying Australian shares is a less unwise decision than would be buying international shares [ie, they are simply unwise to different degrees!!]. To elevate its conceptual credence, you need to add other relevant dimensions to your cuurently potentially distorted/misleading unidimensional statistical analysis 2. I worry about the emphasis on resource stocks with significant iron ore price exposure. The iron ore price is highly inflated by the sharp but temporary decline in Brazilian production/supply. When financially desperate Brazil comes out of COVID-10 lock-down it's Carajas mine [the world's biggest iron ore mine] production will roar again. With that the world iron ore price will fall and with it the value of heavily iron ore-dependent Oz miners like Rio, Fortescue and [to a lesser extent] BHP.. Cheers and keep such great thought-provoking articles coming, mate!

Andrew McAuley

Thanks Robert, we live in interesting times. Yes, market is grappling with absolute valuation given low rates. Should low rates be factored in completely? If so, equities look a little cheap versus risk free rate, not so much versus current PE.

Robert Delforce

Thanks heaps for the follow-up, Andrew. My 1: COVID-19 is SO different to what the current crop of investors have ever experienced. There are so MANY dimensions to it that make any econometric analysis SO challenging as a basis of investment by both individual investors and big, highly respected, world-scale funds like Credit Suisse [C-S] alike. My 2: China's steel-making iron ore demand certainly is a wind behind the world price; but then can it overcome the headwind of Brazil coming out of it re. production/supply/export of i.-o?? World i.-o. price and therefore ASX share prices of RIO and FMG can increase from here ...but that eternal, most difficult question of when to exit the position [or at least take something off the table for possible investment/opportunity elsewhere] looms. BHP has the advantage of being the world's most diversified miner, so you've got more room to maneuver there. The big funds like C-S have the added difficulty vis-a-vis small individual investors that the sheer monetary amounts they handle means they take big chunks of the companies they invest in = versus a relatively small individual investor who can take small chunks of a large number of ASX listings and maneuver readily in and out of any particular holding. But I appreciate big funds look to the LONG-term prospects of stocks like RIO & FMG [and "Beepers"] as potential investments for their client's/members' money. As a small individual investor I have the precious luxury of short-term maneuverability...where my current investment/decision horizon is the lead-in to the Morrison-Frydenberg support and bank repayment holiday bandages falling off the economy wounds in September. Low risk-free bank deposits might look retrospectively brilliant then if large chunk investments made now turn sour then! Cheers again, Andrew.