Labor of love

In the end, it took just two of the independent MPs to provide the support on confidence votes and supply to get the Labor Party across the line and into a second term in government – just.

The minority government’s ability to pursue its agenda will be severely tried and tested against the views and needs of the independent MPs and the Green Party. The latter will ultimately hold the balance of power in the Senate as from 1 July 2011 making the Labor Party’s job even more precarious.

For now, the important implications for the equity market are the continuation of the Minerals Resource Rent Tax and the National Broadband Network. We discussed these issues in our market comment immediately following the 21 August election (FAT488).

It will also be important to watch for possible changes to the taxation regime in other areas. The Labor Party’s progressive reduction in the company tax rate is fundamentally against the desire of the Green Party who wants to increase the corporate tax rate to 33%.

The Greens also want to increase the MRRT to pay for a range of other policies but this will only raise the ire of the big mining companies who will vehemently oppose such a move.

The possibility of a carbon tax will clearly impact the markets but until the details are worked out, it will be impossible to quantify any impact.

The Australian market ought to be doing much better. The financial system is robust, corporate earnings over the last year have been good, consumers are spending money and a host of data emphatically shows the economy is healthy. So why has the price to earnings ratio of the equity market been de-rated over the last year?

The answer lies in a reflection of what the Reserve Bank has been saying month after month for the same period – it’s not Australia where the problems lie, but in the fragility of the big US and European economies. That uncertainty in the overseas markets has overridden the fundamentals in the Australian market and dragged the valuation of the S&P/ASX200 Index to a level below its long term average.

In a strange twist of events, the Reserve Bank of Australia has the reverse problem to the Federal Reserve in the US. The RBA must decide whether to increase interest rates to hold back any chance of domestic inflation getting out of control. The Fed must decide whether to keep its interest rates at or near zero for an extended period and if it should initiate further economic stimulus measures to help the US economy off the floor.

The following chart shows the dilemma the Fed is facing. Personal spending and jobs data are suggesting the economy is doing enough to avoid a double-dip recession but the unemployment rate is not dropping quickly enough to generate a stronger amount of economic activity.

President Obama is separately looking at ways to boost the economy including tax cuts to encourage hiring, personal income tax cuts for middle-America and more infrastructure spending. The cynics only have to point to the mid-term November elections to decry the latest talk from the President but it seems the economy is struggling to recuperate on its own.

In another parallel with the Australian situation, the incumbent Democrats are trying to persuade the electorate that their party is about ‘moving America forward’ while the Republicans would take the US ‘back to the failed policies of the past’.

Just how all this has translated into the equity markets has been an exercise in frustration for Australian companies. Most have used the last year or more to cut costs, improve operating efficiencies, reorganise balance sheets and raise fresh equity. That has resulted in the latest reporting season delivering some quite acceptable earnings growth, yet the equity market has been in retreat for the better part of two years.

The ASX200 index has declined by 14.2% from August 2008 and by just 1.7% from one year ago after the strong rally in the third quarter of 2009. But since the beginning of 2010, the Australian market is again down 9.6% to the end of August leaving analysts to ponder the reasons.

Looking at the performance of the US market over the same time frame suggests much of the Australian performance is due to the US market. Since August 2008, the Dow Jones Industrial Average has declined by 13.2% and is down 4% in the calendar year to the end of August.

As a consequence, the Australian market has been de-rated from a one year forward PE of 15.2x at the beginning of the year to the current 12.1x, despite the increase in earnings per share. The world PE rating at the start of 2010 was 13.9x and is currently 11.7x – a 16% compression.

Within the Australian market, the worst hit sector has been metals and mining with a 42% contraction from a PE of 17.1x at the start of 2010 to a current PE rating of 10.3x. This almost seems an absurdity given the constant refrain we hear that it was this sector that has almost single-handedly saved Australia from any sort of financial hardship across the GFC period. Does this suggest that the metals and mining sector was too expensive at the start of the year or is it now too cheap?

The financial sector has retreated from a PE of 13.3x to a current PE of 11.0x, largely in line with the overall market.

At least a small portion of the market malaise must be attributable to Australia’s political environment. The uncertainty surrounding crucial policies such as the Minerals Resource Rent Tax and the National Broadband Network may be creating a wait and see attitude among investors. Whichever way the politics goes, the economy remains undeniably in good shape.

On balance then, the market should be heading higher by Christmas on the assumption that the US market avoids a double-dip recession (with or without the help of the Fed).

The Reserve Bank of Australia held the cash rate at 4.5% today for the fourth consecutive month. The RBA’s comments were similar to recent monthly meetings citing the trend rate of GDP growth and inflation in Australia, and the high rate of growth in China. The RBA did note the improved outlook for European economies but expects the US economy to be weaker in the second half of the year.

Commodity prices remain high, keeping Australia’s terms of trade at record levels. The RBA believes that business investment could rise strongly as private demand firms in Australia.

Since dipping to an intraday low of 4,313.9 on August 25, we have seen a resurgence of bullish sentiment. This resulted in a break above both the 50 period moving average (green line) and the downtrend line in place since April. This strong move higher has seen a positive cross on the MACD, coupled with the strengthening RSI, bodes well for a continued move higher over the near term.

Key resistance lies at the confluence of the 4,600 psychological level and the major 50% Fibonacci retracement. This level successfully capped two prior advances back in late June and mid August. Lastly, major resistance lies at the 200 period moving average (red line) which sits at 4,628.45, which will no doubt see the bears defend this region.

Since failing to break below the key psychological 10,000 level on three prior attempts during late August, we have witnessed a strong rally follow. The swift move higher resulted in a break above the 50 period moving average (green line) and has closed at the 200 period moving average (red line) and the 50% Fibonacci retracement at 10,448.

The most recent advance was on notably low volume, thus lacks conviction in the move. We would expect a period of consolidation at current levels. However, should the Dow storm past this barrier of resistance, we would expect a test of the August 9 high of 10,719.94 over coming days/weeks.

Gold experienced another clean out, touching an intraday low of US$1,238 on August 3, before finding support from the 12 period moving average (green line) to bounce firmly higher. A sustained break above the US$1,255 resistance level would yield a swift move higher towards the all time high of US$1,265.00.

Historically, Gold generally appreciates roughly +2.5% during the month of September. In addition, this is the strongest month of the year for the yellow metal, as a result of the Indian wedding season and buying from China in preparation for their 'National Day' in early October.