Australia ETFs: Downgrading Down Under

ETF Trends

Back in February, I warned that all was not well Down Under, noting that any further softness in Australia’s growth would lead me to downgrade my near-term view of the country’s stocks.

Since then, a number of leading indicators have suggested that the Australian economy is slowing. So, as I write in my latest Investment Directions monthly market outlook, I’ve downgraded my near-term view of Australia to underweight from neutral.

While Australia posted a strong fourth-quarter 2012 gross domestic product report, more recent local business confidence surveys are pointing to a slowdown in domestic growth. At the same time, the economy faces future growth headwinds including a strong Australian dollar and easing commodity prices.

Australia’s sluggish growth outlook is problematic given that local equities are expensive compared to those of other developed markets. While most market watchers have been focused on the United States rally lately, Australia has actually done better over the last 12 months. Since March 2012, Australian equities have climbed roughly 16% in dollar terms, outpacing most developed markets, including the United States.

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Australia-etf

Thanks to the magnitude of the advance, Australian stocks are now trading for roughly 15.3x this year’s earnings and at a premium to both the United States and Europe. This valuation seems unjustified considering not only Australia’s cooling growth but also the declining profitability of Australian firms. The country’s large mining companies in particular are facing oversupply challenges and potential weaker demand from China.

That said when I look out at an investment horizon longer than a year, Australia is still one of the smaller, developed “CASSH” (Canada, Australia, Switzerland, Singapore and Hong Kong) countries that I like over the long term. The “CASSH” countries exited the financial crisis in far better shape than Europe, Japan or even the United States.

Australia in particular has an exceptionally low debt burden, a budget close to balanced, a profitable corporate sector, a sustainable pension system and a benign inflation outlook. In addition, thanks to its large banking sector, Australia offers one of the highest dividend yields among developed countries.

As such, I would look to upgrade my short-term view of Australia on a pullback in valuations, but for now I’m advocating reducing exposure to this market.

Russ Koesterich, CFA, is the iShares Global Chief Investment Strategist.

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