Is the end of the ASX’s lost decade nigh?

The Australian sharemarket should have returned to its peak by now. It’s been 10 years since the S&P/ASX300 indices rose above 6800 and it’s time it got back to that.

This is the longest period in almost a century the sharemarket has delayed returning to its previous all-time high levels.

Even following the Great Depression and the 1987 sharemarket crash, the market revisited its peak at least sometime within the 10 years following those events. The ASX is behind schedule.

" This is the longest period for almost a century the sharemarket has delayed returning to its previous all-time high levels."

To be fair, we did suffer the devastating blow of the global financial crisis almost immediately after the market peak in 2007. Since then it’s been a slow but fairly steady pace to regain value.

ASX/S&P 300 index performance 2007-2017

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Underperforming

The key reason the ASX is underperforming is the stocks themselves: Australian companies are not earning enough to push share values higher. There is a very close relationship between companies’ earnings and sharemarket performance.

The major reason for this is the commodity boom is well and truly over. Australia’s resources companies are only earning half what they were 10 years ago, reflecting the collapse in commodity prices.

For example, iron ore has suffered a 67 per cent fall in the past decade, closely followed by coking coal which has fallen 43 per cent. But even outside the weaker resources sector, earnings for the wider market are below the 2007 peak by around 10 per cent.

Sharemarket performance v earnings performance

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We can see the relationship between company earnings and sharemarket performance very easily taking a quick look back.

• Before the China boom from 1993 to 2003, trend earnings growth was 3 per cent

• In the commodity boom earnings exploded, doubling in four years (2004 to 2007)

• During the global financial crisis earnings fell under a weaker economy

If we had remained on the 1993 to 2003 trend (and there was no boom or crisis), earnings would have risen sufficiently to put the market beyond the 2007 peak by now.

But the global economy and markets changed significantly in the wake of the financial crisis, leading to where we are now.

Unrelenting

The crisis put a stop to China’s unrelenting rapid growth in demand for our resources, the surging growth of developing economies and a loose, easy state of financial affairs fostered by lax regulations.

Looking carefully at the sharemarket and company performance we can now see:

the pace of growth has slowed, partly because Australian companies pay out profits rather than reinvest them in their business; and
return on equity (a measure of profitability) has collapsed well below its peak in 2007 and hasn’t come anywhere near reclaiming that level.

What these trends do indicate is shares are now fairly valued (compared with when the market peaks and they’re typically 50 per cent overvalued). The conclusion is the market is within striking distance of its 2007 peak - but a few things still need to go right.

Global perspective

Globally, sharemarkets over the year to September returned 20 per cent. The Australian market was somewhat weaker, returning around 9 per cent. Nevertheless that's still quite a solid return.

The question, of course, is how much longer it can go on? In an uncertain world it’s best to focus on the fundamentals. What is happening in the economic cycle? Then we look at the valuations. How much are we actually paying for the shares we buy? These two things are critical.

When we look at what's happened in the last 12 months what we find is a strong sharemarket made sense. We had a stronger global economy, inflation was somewhat higher and profitability grew.

All of these things were positive in driving profitability and therefore markets. If we actually go back and have a look at the extent of this length of the cycle, it's been going for a long period of time.

Unemployment is low amongst the global economies such as the United States, Germany, the United Kingdom and Japan.

So how much longer can it go on? The key thing which usually brings to an end a rally or an economic expansion is higher interest rates. This is what happened in 1987 when US bonds rose 3 per cent over the year to the crash.

Why are interest rates historically low? Negative in Japan, negative in Europe and modest, around 1 per cent or so, in Australia or in the US.

It comes down to inflation. At the moment inflation is still low. Central banks are keeping rates low to drive growth. While the United States is raising rates they're doing it very gradually.

There is no doubt as we move into 2018 the risks will actually begin to build. Inflation is picking up in the US. Will we get higher inflationary pressures? ANZ’s view is they will gradually come through.

While we're aware of the risks, we think there's still a while ago left to go in this sharemarket rally.

Return

With the price-earnings ratio for listed Australian companies now above trend, stronger company earnings are the most-likely catalyst of a return to sharemarket highs. Australia’s underperformance in recent years may now well be followed by a period of better returns.

Whether we scale to previous heights will, as always, be dictated in large part by the global investment cycle. At this stage it’s giving a glimmer of hope as economic growth remains strong without the usual concerns about inflation.

Mark Rider is Chief Investment Officer, ANZ Wealth Australia

The views and opinions expressed in this communication are those of the author and may not necessarily state or reflect those of ANZ.