Greg Smith: 'Splashing the cash' – the case for Aussie equities

The resource sector has been a key driver of the economy and stock market. Photo / Getty Images

OPINION:

In a week where the prospect of surging inflation is starting to unnerve investors, it is perhaps fitting that the Australian stock market made a record high on Monday.

Our transtasman neighbours have also handled the pandemic better than most, with strong health and financial outcomes. The country's resource has also played a big part, amid strong commodity demand from China in particular, and pricing strength to go with it.

Overall, rising business confidence has helped to propel the economy to the point where there are now more jobs available than there were pre-Covid.

This was all very evident in the Federal budget released this week in which Treasurer Josh Frydenberg "splashed the cash" with $95 billion of extra spending over the next five years. An upbeat economic picture was painted, alongside several big spending pledges, including almost $30b in personal income and temporary business tax cuts. The budget aims to create 250,000 jobs by the end of next year and help drive the unemployment rate below 5 per cent.

The bill to pay will be much lower than it could have been. The deficit is forecast to reach $161b this year (2020-21) or 7.8 per cent of GDP, $53b less than forecast six months ago. The deficit is expected to drop to $57b by 2024/5, with more than $100b in additional revenue forecast over the next four years since the December budget update.

The resource sector has been a key driver of the economy (and stock market) with robust demand, and rampant pricing (helped by a weaker US$) delivering a $50b budgetary windfall. The government had forecast iron ore prices would be around US$55 a tonne about now – they have hit a record US$230 a tonne this week (and are up 50 per cent year to date). The Treasury has left this conservative assumption within their models, meaning there could be an additional $12b in revenue, even if prices were to fall back to US$150 a tonne.

This has been hugely positive for the big iron ore producers such as BHP, Rio, and Fortescue, and somewhat ironic given increasing trade frictions between China and Australia over the past year. While targeting many of Australia's exporters, China appears to appreciate it has nowhere else to turn to, at least in the short term, for the massive quantities of the steel-making ingredient to propel an economic reboot.

There is also then the prospect that these infrastructure-led investment initiatives (also a feature of Australia's budget) will be replicated across the world. This will require lots of steel (which iron ore is used to produce), along with a host of other commodities (including copper which also hit record highs recently), and potentially fuel a multi-year bull run in resources.

Share prices of the big miners have been on a tear, and clearly there are some risks about buying into any of these big names at current levels. It is worth pointing out, however, that unlike previous secular bull cycles, financial discipline has been much tighter (which could make this cycle more durable), and dividend pay-outs are amongst the strongest on the bourse.

Dropping down the market cap scale, there are an array of commodity related companies (and very large by NZ standards), which are exposed to various other thematics, including nickel producers which are set to ride the wave of electric vehicle production in the years ahead (the average EV could contain up to 30 kilograms of the metal).

Energy is another big sector of the Aussie market, and is well positioned to leverage robust energy prices, rising demand from Asia, and with the Australian government pushing gas capabilities domestically.

And then there's gold. Before crypto-currencies, gold was seen as the "go-to" safe haven against the debasement of fiat paper. The precious metal hit a record high of around US$2070 last year, and could well surge again as inflation becomes more prominent. The ASX is blessed with many high-quality gold names, and sizeable ones at that – the top 10 gold producers all have market caps north of A$1b.

The other big driver of the Australian market's momentum, since November at least, has been the banks. It was very clear that if the economy were to have a better than feared outcome from the pandemic, then the billions of provisions that were made for Covid-related bad debts would not all be needed.

This was very much the message coming out of the recent reporting from the banks (including CBA, the nation's biggest lender, which delivered quarterly results this week), with bad debts nowhere near the level expected, and some provisioning released.

With lending volumes on the up (both business and retail), net interest margins recovering, and large levels of excess regulatory capital, this could leave scope for higher dividends from the banks later in the year, along with capital initiatives such as buybacks.

Ultimately the banks are a strong play on the growing economic rebound, and one which is also being underwritten by the Reserve Bank of Australia. The central bank, like many others, remains in accommodative mode, although a commitment to keeping the cash rate at 0.1 per cent till 2024 will likely be hard to justify given the positive economic outlook and rising inflation.

It is worth highlighting that the financials are materials sectors make up over 50 per cent of the ASX200. Should they both operate in upward tandem together on the back of the reflation trade, it is conceivable the Aussie market can push much further on the upside.

This could also extend the relative outperformance against the kiwi stock market which has occurred over the past 12 months. Indeed, 8000 may even be a legitimate target for the Australian index in 2022, with the economy set for another lift as and when international borders reopen fully.

There are a host of other sectors and companies across the Australian market, and these arguably offer a greater investment choice than the kiwi market. There is plenty of "sizzle" among the more than 2000 companies on the wider exchange, but also a host of large blue-chip names across the healthcare (another winner from the budget), real-estate, industrials, and consumer sectors, but to name a few. Many of the constituents here could well continue to ride the "V" shaped economic recovery, which appears to be gaining momentum.

Another vote of confidence in the broadening economic recovery in Australia is evidenced in the level of merger and acquisitions activity. The past week alone has seen an $8b takeover move within the construction sector, and a merger proposal to create a $12b casino and gaming behemoth. Added to this there are a host of new companies coming to the market – over the next month alone there are 20 new listings planned.

There are clearly still risks in investing across the Tasman, and Australia has also seen some market "darlings" lose significant altitude in recent months. Buy-now-pay-later stocks such as AfterPay have deflated at a rapid clip since their February highs, as investors have awoken to the prospect of increasing competition, and rising bond yields, which will make stratospheric valuations even more so.

But to summarise, there are a host of high-quality companies on offer across the ditch in our view. Kiwi investors looking for offshore equity exposures could do worse than consider the Aussie market, and potentially the buying opportunities that may emerge if the seasonal "sell-in-May" correction plays out again (2020 was a stark exception) this year.

• Greg Smith is the head of research at investment research and funds management house Fat Prophets.