Historically there had been a reasonably high degree of correlation between the US and Australian share markets, with the old investment adage being “the US sneezes and Australia catches a cold”. Since the GFC this relationship however appears to have broken down, with the US outperforming the Australian share market by more than 6% p.a. or a staggering 95% in total in local currency terms.

The 2014/15 financial year unfortunately saw a continuation of this all too familiar pattern, but encouragingly the US outperformance was nowhere near as stark as in previous years.

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Source: Bloomberg

 

So is it time we gave up on Australia and ploughed our money into the US?

To answer this question we first need to try and isolate what has caused this US outperformance, which we believe can be attributed to two significant drivers – low interest rates and a boom in corporate profits.

The first driver makes perfect sense – when faced with the prospect of 0% interest on your bank account savings, a 2.5% dividend looks particularly attractive!

Secondly, US companies have enjoyed very strong earnings growth, with earnings per share (EPS) for the S&P500 now 40% above the pre-GFC peak assisted by zero interest rates, a weaker USD and subdued wages growth.

For Australian companies the opposite has been true, especially in the first few years post-GFC as our mining boom distorted interest rates, the Aussie dollar and wages. Consequently company profits stagnated, stuck in what seemed permanent low gear.

But will these drivers of the relative outperformance continue to favour the US?

Our view is no, and in fact at Elston we have moved client’s diversified portfolios to an underweight exposure to US equities. We believe that the 3 levers that drove the relative profit boom in the US have largely played out there, and are now weighted in favour of Australian companies given the US economy is improving at a time that Australia needs to deal with a mining bust.

These different economic realities mean:

1. Diverging interest rate policies – the RBA has cut the cash rate from 4.75% to 2.00% with the bias for further easing without fear of causing inflation. This lowers the borrowing costs for companies and supports the non-mining parts of the economy such as retail, property and construction.
2. Falling AUD versus strengthening USD – after punching above its weight for a number of years, the little Aussie battler has fallen from above parity to around USD$0.70 providing a significant boost to exports and making it more difficult for imports to compete with Australian domestic companies. This will start to flow through to company profits growth and higher dividends, initially from currency translation benefits, but subsequently also via increased corporate competitiveness.
3. Subdued domestic wages growth too – as the mining sector decreases in terms of its relative importance to employment and jobs growth, we are seeing less wages growth and increased unemployment. This reduces cost pressures for business, which combined with previous initiatives by Australian companies to reduce their cost bases should boost profit margins.

So while investors all too often get stuck focusing on last year’s best performer, this is not a viable investment management technique for working out what is going to happen in the future. We see the changing conditions doing for Australian companies what they have done for those in the US in recent years, and are thus excited by the opportunities for local companies and encouraged by the potential for earnings growth down the track.

If you would like more information please call 1300 ELSTON or email info@elston.com.au and an adviser will be in touch.