A key theme of the February profit reporting season is likely to be the extent to which stronger economic growth in Australia and overseas have offset the negative effect of a stronger A$ on domestic company earnings. Very strong retail spending and business confidence data suggest the reporting season is likely to be positive for retailers and domestic media companies. Sectors likely to experience strongest earnings growth are Telecommunications (+68%) and Financials (+32%), driven by strong equity market returns for insurers. In contrast, sectors likely to experience the largest negative earnings growth are Energy (-9.4%), driven by an expected 19% fall in Woodside Petroleum's net profit and Industrials (-6.2%), driven by Qantas (analysts expect its net profit to be down by 14.8%).

As we enter the 2004 reporting season, the largest earnings downgrades have been in Materials (-7.5%) and Healthcare (-3.2%). This can be largely attributable to A$ appreciation. Pressure on profits from the stronger A$ is likely to be greatest for basic material producers, exporters of wine, and medical device companies. In addition to the translation effects of converting US$ profits into A$, the stronger domestic currency is also likely to have a negative impact on Australia’s international competitiveness.

For resource companies, commodity prices were more than offset by the stronger A$ in most cases. Exceptions were gold (e.g. Newcrest) and nickel (e.g. Newcrest and Western Mining Resources). Looking forward, however, we expect very strong global demand in the first half 2004 to boost demand for commodities, more than offsetting the adverse impact of currency on resource company profits.

Profit outlook

Although the macroeconomic environment should remain positive for aggregate profit growth in the first half of 2004 (due to strong consumer spending, business investment and global growth), rising interest rates and the sharp appreciation in the A$ suggest some fundamental deterioration is likely later this year. In particular, broad financial conditions are already contractionary. The chart below is our measure of real financial conditions in Australia. It combines the year-on-year change in share prices, money supply growth, the real cash rate, yield spread and the trade weighted currency.

The sharp appreciation in the A$, the 50 basis point increase in the official cash rate by the Reserve Bank and the narrow spread between the 10-year bond/3 month yield suggest a sharp moderation in GDP growth in the first half of 2005. In contrast, other indicators such as the National Australia Bank’s Business Survey are consistent with very strong GDP growth (around 5% in 2004) and a solid profit outlook. While financial conditions are deteriorating, business and consumer confidence remains strong and the global economy is likely to be very supportive for the local economy.

In our opinion, aggregate profit growth is likely to moderate from around 14-16% in the first half of 2004, to low single digit growth in the second half of 2004.

Chart 1 – Australian Real Financial Conditions vs real GDP growth*

Source: Bloomberg * GDP growth has been converted to a smoothed monthly series

On the positive side, companies exposed to the strong global cycle are likely to continue to benefit from exceptionally strong growth in the United States and emerging Asia. As noted in previous editions, our catalyst for moving to a more defensive asset allocation is likely to be the anticipation of the US Federal Reserve beginning to increase official interest rates. We expect this to occur around mid-year.

Key points

• A key theme of the February profit reporting season is likely to be the extent to which stronger economic growth in Australia and overseas have offset the negative effect of a stronger A$ on domestic company earnings.
• While the macroeconomic environment should remain positive for aggregate profit growth in the first half of 2004, rising interest rates and the sharp appreciation in the A$ suggest a relatively poor fundamental outlook over the coming 12 months.

Investment strategy

• There were no changes to investment strategy during January. The JBWere Diversified Growth Fund remains modestly overweight Australian equities and 3% overweight international equities. Strong above trend economic and profit growth is likely to maintain equity market performance through the first half of the year. However, we are likely to be more cautious around mid 2004 as the profit cycle begins to slow and interest rates in the major economies begin to rise.

Nick Ferres is an Investment Manager at Goldman Sachs JBWere Asset Management. His key responsibilities are management of the JBWere Diversified Growth Fund and analysis of economies and markets to assist in the formulation of asset allocation strategy.