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China helps put miners back in the winners' circle

Elizabeth Knight

In the next couple of weeks, investors will see real evidence of the fact that the Australian corporate earnings drought has broken. After two years of falling profits, they are now expected to rise about 6 to 7 per cent.

For this significant turnaround we need have only one source for gratitude: China.

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Australia calls time on commodity rally

A commodities rebound that’s seen iron ore and coking coal surge and boosted earnings at global miners is set to peak this year.

This is a China-led Australian earnings recovery based on increased prices it is paying for a number of our mineral resources, most specifically coal and iron ore.

Thus the real gains in earnings will come from resource companies such as BHP Billiton, Rio Tinto and Fortescue, whose earnings in the previous couple of years had fallen off a cliff and taken the aggregate Australian market profits with them.

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This year will see these giant mining companies regain hero status.

This, combined with the so-called Trump bump, has been a major factor in the strength of the Australian sharemarket over the past couple of months.

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That's the good news.

The bad news is that the remainder of Australian companies – in particular industrials – won't experience much of a profit bump.

Yet they have also experienced sharemarket gains, the justification for which may now be in question.

Share price movement can reflect a number of factors but, in essence, they reflect movements in future earnings.

If one takes resources companies out of the mix, 2017 earnings are expected to improve by a far less stellar 4.5 per cent, according to Citi.

On the face of it, the fact that even without resources there should be aggregate earnings growth seems pretty positive.

But as UBS points out, the narrowness of the growth pick up is concerning. And if one dives a bit deeper into what is driving non-resource based earnings, improvement it is more unsettling.

A couple of big stocks, such as Woolworths and CSL, are coming off disappointing performances in 2016, and they will be responsible for a disproportionate portion of the improvement.

Citi is looking at a significantly better year for retail in general but a lacklustre improvement coming from banks.

Ultimately there are some positive sectors but the stagnant economy and the wary consumer are not behind the overall revival in corporate profits in 2017.

Thus companies are not self generating their own profit improvement. This year's gain in overall corporate earnings is about what China is doing to stimulate its economy rather than what the Australian government or company executives are doing to increase demand.

Macquarie Group, which is generally more positive about 2017 earnings, still notes that, "the economic backdrop remains broadly unappealing with volume growth and pricing power low. However, this allows scope for strict cost control. Hiring is weak (and becoming more variable over fixed), wage growth is low, rents have been falling (outside of Sydney office) and the cost of debt, until recently, was lower than a year ago".

From an economic perspective Westpac said this week it was expecting "modest growth in household spending; a contraction in residential construction activity and, possibly, a slowdown in services exports will restrain employment growth. While prospects for a modest fall in the unemployment rate in 2017 seem reasonable it is likely that it will move back towards 6 per cent in 2018. In such circumstances it appears unlikely that the inflation rate will rise much above the bottom of the 2-3 per cent target band".

In general, it's predicted to be another year of attention to cost cutting and another earnings season in which companies will seek to maximise the dividend payments.

The construction boom that offset the fall in mining investment is likely to come off the boil while healthcare stock profits growth is expected to moderate.

According to Citi, the stocks that may surprise the market with better than expected earnings include Fortescue, Rio and Woodside Petroleum. UBS reckons Harvey Norman, Super Retail Group, Costa Group Holdings, JB Hi-Fi, Boral, Cleanaway may also produce a better performance than the consensus.

Those that can potentially disappoint include Tatts Group, Telstra and Wesfarmers, according to Citi.

In these circumstances, where a narrow group of mainly mining companies will be doing the heavy lifting on earnings growth, investors will need to rely on external factors such as the continued Trump halo to spur equities markets higher, rather than more general buoyant company profits.

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