Australian equities have been getting bad press with some investors warning they are significantly overvalued. The narrative goes that we’re in the midst of a housing bubble that will blow up and take the share market down with it.
Like every story there are elements of truth to this, but if you silence the noise and take a long-term view – as most investors should – Australian equities remain a strong investment choice.
“If you compare Australian equities to bonds and other alternatives, they still look reasonably attractive,” says Tom Young, portfolio manager, Australian equities at AMP Capital. “The market might fall every decade or so, but to maximise your gains, your best bet is to be in the market through the cycle.”
By avoiding Australian shares in the short term, investors and advisers might sidestep some market risk; but they will face a greater risk: missing out on solid long-term dividends and growth, and tax benefits, that are vital to reaching financial goals.
Climbing a wall of worry
Our Head of Investment Strategy and Chief Economist, Shane Oliver, recently said the Australian market has climbed a wall of worry.
Australian equities bears have a long list of worries. They rightly point out the Australian market is at historically elevated levels. The forward price-to-earnings (PE) ratio, which uses forecast earnings for the next financial year, is around 15.5 times for the ASX200. That’s above the 15-year average of 13.7 times.
They also note the Australian equity market is highly concentrated in the big resource stocks and banks. The banks, they say, are particularly risky in light of the Turnbull Government’s $6.2 billion levy on the major banks.
Young agrees that, while the banks will pass the levy on to customers, its introduction is quite negative for banks in the longer term, “It’s very easy for Government to pull that lever [a bank levy],” he says. “It creates an environment where bank profits are subject to government approval.”
“Australia is nowhere near as punitive as countries that saw much bigger banking crises during the GFC, such as the UK and US,” he adds. “Australia could be heading down that route which could be a drag on banks.”
But Young says a bigger concern is actually a crackdown on interest-only lending, with regulator APRA limiting interest-only loans to 40 per cent. That could flow through to the broader economy by cutting discretionary spending, which would hurt the banks.
No housing bust
But the biggest concern for Aussie equities bears is a possible housing market bust. Young says the housing market is a bit frothy and could fall. Sentiment is already switching to negative. But he notes that while the market is softening, “we don’t see the market blowing up.”
A housing bust will only be triggered by a surge in unemployment and high interest rates. “At the moment unemployment is looking alright and interest rates are stable and probably going to remain stable,” Young says.
Even if the housing market falls, Young says the growth baton will pass to infrastructure spending. “The housing boom, which helped us weather the mining downturn, is at the end of its life, but the next leg is going to come from Government spending on infrastructure.”
The risks around the housing market, big banks and the Australian economy are manageable.
And while Aussie shares may be trading at healthy valuations, relative to other investments – particularly when it comes to yield and income - Australian equities look strong.
Australian equities are yielding 4.5 per cent; add franking credits and that increases to 6 per cent. The Australian 10-year Government bond, by contrast, is yielding just 2.5 per cent.
“The income from Australian equities remains pretty attractive relative to bonds at this point in the cycle,” Young says.
Australian equities are particularly good options for income investors that aren’t so worried about volatility. Since 2010, the Australian market’s total return was 60 per cent. Over half that has been due to dividends. “We’re pretty confident that yield [of around 4.5 per cent] will continue,” Young says.
Australian shares, of course, benefit from franking credits, which investors don’t get in international shares. This increases Australian equities’ relative after-tax return and makes them particularly compelling investments for super funds and retirees.
For every 70 cents of dividends, investors can receive a tax credit of up to 30c, which equates to 43 cents per dollar of dividends. Franking credits are refundable as cash payments to low-tax investors. Retirees paying 0 per cent tax will be able to receive an uplift of up to 43% on each dollar of fully franked dividends, significantly boosting returns.
A long-term view
There’s no doubt the Australian equities market is overly concentrated in housing-exposed banks and cyclically-challenged resources.
Given Australian shares only make up 2.5 per cent of global equities, there is also room for most investors to diversify offshore. And – as usual – there are risks.
And the Australian market has negative returns roughly two out of every ten years.
But most investors need to take a very long-term perspective. Most investors will hold Australian equities in their portfolio for 20 to 30 years or even longer. A 20-year-old who lives to 90, could be invested in Aussie equities for 70 years! Even a retiree at 65 who lives to 90, will hold them for 25 years.
From that long-term perspective Australian shares, despite the concentration risks and the need to diversify portfolios, still look attractive as a source of income and growth.
The Australian market might have some risks, but given its long-term potential it’s riskier not being invested in it.
“On average, the Australian equities market goes up,” Young says. “If you own the market for a long period of time you should make money.”
Tom Young, Portfolio Manager, Australian Equities