A lot has been made over the last month about the ASX 200 breaking through the 6,000 barrier. In doing this it reached the highest level since the Global Financial Crisis. A number of commentators have pointed to the psychological impact of breaking this round number and have suggested it could herald a sustained rally. We, however, are not so sure and in order to understand why we think it’s important to look at the structure of the Australian equity market and what its potential drivers are.
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Over the last 10 years the S&P 500 has given investors a return of 106.3% or 7.51% annualised whilst over the same period the ASX 200 has delivered just 37% or 3.2% annualised. One of the key reasons for the Australian market lagging is the evolution of the US market over time. To illustrate this point the chart below looks at how the top five companies in the world and how they have changed over the last decade.

The most notable aspect is how the composition of the top five has evolved over time away from Energy (Exxon, Total, PetroChina) and Banking (Citi, ICBC) to Technology. The technology sector globally has been the key driver of the recent rally and the major source of earnings growth. One can point to current valuations and suggest that the Technology sector has run too hard and too fast. We would certainly agree that the likes of Facebook, Amazon and Netflix do trade at very high multiples, but with a lack of growth in other sectors, investors remain attracted to them.

Australia has missed out on this latest boom as the Technology sector currently represents just 1.8% of the ASX 200 and has a limited impact on the direction of the market. In fact, amazingly when you do a similar comparison of the Australian market you see that the companies at the top have barely changed over time. Amongst the top five companies in Australia, only one has changed since twenty years ago with ANZ replacing News Corp. This leaves us with four banks and a miner in the top five and highlights the concentration risk in the Australian economy to just two sectors (housing and mining). It is therefore these two sectors that will dictate to a large extent the direction of the ASX.

In order to understand where we are going it is often quite helpful to look where we have been. As the mining construction boom came to an end back in 2012, the RBA started to cut interest rates and this in turn led to a residential construction boom (something we wrote about here). The key driver was low interest rates encouraging consumers to take on debt; as a result Australian consumers took on more leverage at a time when consumers in most of the developed world were going the other way.

This was a significant tailwind for the banks. Higher demand for credit allowed them to continue to grow their asset books (as discussed in this article here) and this has led to profit growth. The question now is whether this growth continues and to that end we have started to see consumers begin to get squeezed by a combination of factors. These factors are the previously mentioned high debt levels combined with continuing low wage growth, a raise in interest rates through APRA intervention (on interest only and investor mortgages) and a 17% jump in electricity costs. As a result retail sales have fallen over the last three months and the property market has started to slow. The easiest way to measure demand in the property market is the auction clearance rates. These have started to fall with Sydney having recorded rates of below 60% for the last four weeks suggesting consumers are less willing (or less able) to take on more debt.

The impact for the banks will be constrained asset growth and if the situation worsens, rising impairments. The major banks have responded to this outlook by a further round of cost cutting with NAB in particular announcing that nearly 1 in 5 people will be made redundant. The outlook for the banks in our opinion remains one of low growth at best and therefore we don’t expect a meaningful rerate of the share prices to drive the market.

That brings us to resources which has been one of the key drivers of the recent rally.  Commodity prices have rallied from December 2015 lows as China fell back on the infrastructure and property lever to boost their economy. Whilst prices have rallied they remain below their 2011 highs. Global growth has picked in recent times but China remains the overwhelming centre of demand, consuming between 50-60% of most raw major raw materials. As a result the ever expanding debt levels of the Chinese corporate sector remains the key risk.

One area within commodities that has seen significant speculation in recent times has been electric vehicles and battery use in general. With a shift globally occurring, the expectation is the demand for commodities associated with battery production will boost prices. Whilst we can see the increase in demand that is occurring we would point any investors interested in the sector towards a recent Massachusetts Institute of Technology study. This study looked at the five commodities most likely impacted by increased battery production, which are lithium, cobalt, manganese, nickel, and carbon in the form of graphite. The study found that the increase in demand from planned battery manufacturing will not lead to significant supply problems. There are however political risks, in particular for cobalt where a substantial part of the supply comes from the Democratic Republic of the Congo. Whilst speculation can always push prices higher, this study suggests the fundamentals may not necessarily line up. Of course the other major threat is the evolution of the battery technology that may remove some demand.

Ultimately, commodity prices are nearly impossible to predict and whilst there could continue in the short term, the rally over the last 18 months potentially limits how much further they can go.

So with both of the major sectors unlikely to provide significant earnings growth, our expectation is that the ASX 200 has limited upside. That is not to say that the recent rally is over, share prices can fluctuate and it would not be surprising to see the market 10% higher (or lower) in six months’ time. However without sustained earnings growth, any upside will be capped. This is the key difference between the Australian and the US market, the US market has evolved and earnings have been driven by innovation whilst the Australian market continues to be dominated by old industries.

That is not to say we don’t have innovation within Australia. There are a number of smaller companies that have done and are doing exciting things. Our portfolio has benefitted from owning companies such as Altium, Hansen Technologies and Gentrack. These are global technologies operating in niche sectors with structural tailwinds providing earnings support.