It Might Be Time for a Healthy Reality Check on Australia Stocks

(Bloomberg) -- What will it take for Australia’s market watchers to come back to reality?

Profits fell short of estimates at almost half of the firms that reported full-year earnings last month, everyone from banks to chicken farmers say they’re getting squeezed by rising costs and a government shake-up is likely. Yet analysts have barely trimmed earnings projections and even raised their 1-year estimates for the benchmark S&P/ASX 200 index by over 1 percentage point since the start of August.

“Consensus earnings forecasts for the next two years are probably too high,” said Matthew Ross, a Melbourne-based equities strategist at Goldman Sachs Group Inc. “Cost pressures are going to catch up and undo some of the better revenue environments.”

It Might Be Time for a Healthy Reality Check on Australia Stocks

Australian equities trade near the highest level in more than a decade even after an emerging-market rout and global trade friction sent the benchmark index tumbling 2.7 percent in the last nine days. An earnings season in which almost half the firms reporting full-year results missed estimates did little to chasten sell-side analysts, who nudged the 12-month target for the benchmark to just over 6,500 from about 6,435 at the start of August, according to price targets for individual stocks compiled by Bloomberg.

Here are four reasons for a little less optimism on Australian stocks:

1. Costs Up

A drought that’s hit Australia’s grain farmers is raising costs for agricultural businesses like poultry producer Inghams Group Ltd., which said it’s facing higher prices for chicken feed.

At the banks, which make up almost a quarter of the benchmark index, margins are being squeezed by higher borrowing costs as Federal Reserve rate hikes add to tighter financial conditions globally. Even after Westpac Banking Corp. last month raised home mortgage rates, analysts said the bank will recover only about half the 11-basis-point drop reported in its net-interest margin during the three months to June 30.

For National Australia Bank Ltd., the only one of the big-four banks not to raise lending rates so far, the hit could be more severe. Still, the average of sell-side-analysts’ forecasts shows the stock rising about 11 percent in the next 12 months.

It Might Be Time for a Healthy Reality Check on Australia Stocks

The squeeze comes amid a softening housing market and concern the financial sector will face tighter regulation after a public inquiry this year exposed widespread wrongdoing that included bribe-taking, falsifying documents and extracting fees from dead customers.

Mining companies and airlines are being hit by oil prices that rose 19 percent in the first half of 2018 and remain elevated. For Rio Tinto Group, that means higher costs at its iron ore unit, which accounted for about 57 percent of earnings in the six months to June 30.

Qantas Airways Ltd. said its fuel bill in fiscal 2019 will rise about 21 percent from last year, according to company filings. That’s the most in seven years, Citigroup Inc. analysts led by Jakob Cakarnis wrote in a note to clients. Still, the average of analysts’ forecasts shows the carrier’s stock adding 12 percent over the next year to a fresh record.

2. Capital Boomerang

Business confidence has fallen to its lowest level in two years and companies are choosing to give money back to shareholders rather than invest in new plant and equipment. Among firms reporting full-year earnings in August, special dividends and other payouts rose almost 14 percent versus 2017, according to Commonwealth Bank of Australia.

In the next 12 months, BHP Billiton Ltd. may return as much as $20 billion to shareholders, UBS Group AG analysts wrote in a note to clients, citing a meeting with chief executive Andrew Mackenzie after the August earnings report.

Dermot Ryan, a portfolio manager at AMP Capital Ltd. said Australia’s uncertain political climate may impact or delay company decisions to invest in projects. The government failed to deliver on corporate tax cuts or energy policy before changing leaders last month.

“Instead of using the money to spend, they’re using it to increase their dividends and return capital to shareholders,” Ryan said of companies that have good balance sheets. “But obviously in the long-term you need to invest to grow.”

3. M&A / Spin Offs

A flood of Australian companies are looking to sell or spin-off businesses, which generates short-term gains but can crimp long-term revenue. Assets worth more than A$60 billion are set to shift hands over the next 18 months, according to Bloomberg calculations based on company filings and analyst estimates.

  • Commonwealth Bank of Australia and National Australia Bank are both looking to offload wealth management units. Commonwealth Bank’s spin off may create a business as large as AMP Ltd, according to analyst estimates.
  • Woolworths Group Ltd. is seeking to dispose of its fuel sites after a $1.3 billion deal to sell the portfolio to BP Plc was scrapped after being rejected by competition regulators.
  • Caltex Australia Ltd. is considering selling a stake in the property assets that house its fuel sites.

4. Politics

With support for the Liberal-National coalition at its lowest since February 2015, according to Newspoll, national elections due in about eight months are on course to deliver a government led by the Labor Party, which has historically been bad for the stock market. Total returns on Australia’s benchmark index have lagged global equities when Labor has been in power, according to data compiled by Bloomberg.

It Might Be Time for a Healthy Reality Check on Australia Stocks

The trend could continue given Labor’s tax proposals for removing investment offsets and dividend credits, according to Ross, the Goldman strategist.

“The fact that the political environment has swung pretty heavily in their favor might be a contributing factor” to the Australian stock sell off last week, Ross said. “A number of Labor party policies are on balance a little bit negative for the equity market.”

©2018 Bloomberg L.P.