ON THE MARKETS2013 is shaping up as a year that will be dominated by earnings performanceON THE DOLLAREven if the RBA cuts rates and commodity prices fall, the dollar is likely to remain above parity

ON INTEREST RATESThe target cash rate is likely to be cut from 3 per cent to 2.25 per centWHERE TO INVESTCompanies exposed to the improvement in the US and China are well-placed to outperform

Matt SherwoodHead of investment markets research at Perpetual

ON THE MARKETSWe would see the market as relatively fairly valued at presentON THE DOLLARThe inability of policymakers to suppress market forces indefi nitely will drive the dollar back towards fair value

ON INTEREST RATESThe offi cial cash rate is likely to drop another 50 basis points to 2.5 per centWHERE TO INVESTWe tend to fi nd more selective appeal in sectors that have done poorly, such as materials and energy

Andrew FlemingDeputy head of Australian equities at Schroders

ON THE MARKETS2013 is potentially very positive for equities relative to debt productsON THE DOLLARIt is possible that it will remain at or above parity for some time

ON INTEREST RATESRates will fall further if infl ation remains within the RBA target rangeWHERE TO INVESTWe like healthcare, retailing, leisure and some international earners

Paul CuddyCEO of Bennelong Investment Partners

WHAT THE EXPERTS SAY

ON THE MARKETSWhile we do not expect to experience Armageddon, we are likely to see some ongoing volatilityON THE DOLLARAustralia will continue to give global investors good cause to buy our currency

ON INTEREST RATESWe expect two interest rate cuts of 25 basis points each by mid yearWHERE TO INVESTWe are sticking with Telstra and the banking sector with their fully franked dividends

Winston SammutCEO of Maxim Asset Management

ON THE MARKETSWe anticipate greater dispersion of returns among stocks than in 2012, so stock picking will be paramountON THE DOLLARIt is diffi cult to forecast a signifi cantly lower dollar at this stage

ON INTEREST RATESThe RBA may be slower in making cuts than some in the market expectWHERE TO INVESTWe see opportunities in companies embarking on aggressive restructuring

Andrew WestPortfolio manager at Regal Funds Management

ON THE MARKETSWe fear the risk-return balance is already becoming challenged in many casesON THE DOLLARIt is conceivable the dollar could remain quite elevated over the course of 2013

ON INTEREST RATESInterest rates may remain under pressure due to the high dollarWHERE TO INVESTWe will focus on the price of a security relative to our appraised value

Erik MetanomskiDirector at Lanyon Asset Management

TOP FUNDS’ BEST PICKS FOR 2013Investors have cause to be cautiously optimisticabout the year ahead, although there are still risksto avoid. In this exclusive survey, The WeekendAustralian asks six of the country’s top fundmanagers for their best investment tips for 2013

ANDREW MAINWEALTH EDITOR

The S&P/ASX 200 index climbedby more than 14 per cent in 2012,above many people’s expec-tations. Where do you believe itmight finish in 2013?

Matt Sherwood, head of invest-ment markets research, Per-petual:EVEN though the majority ofinternational sharemarkets rose,most of them (including Australia)recorded negative earnings pershare growth, with the market riseunderpinned by higher valuations.

With Australian sharemarketvaluations now above their25-year average in spite of adeteriorating profit outlook, 2013is shaping up as a year that will bedominated by earnings perform-ance more than anything else.

With fiscal austerity, the min-ing investment boom and strongterms of trade coming to an endand households increasingly re-ducing debt despite lower interestrates, there will be increasing top-line revenue pressure on corpor-ate earnings in 2013.

One concern is there is littlerisk priced into markets for nextyear, with valuations above theirpost-1988 average in expectationof an earnings recovery. However,Australia’s 2013 economic outlookis progressively weakening.

As such, Australia’s post-September 2009 side-trend is like-ly to remain intact in 2013, with anend-year price target of 4510.

Andrew Fleming, deputy head ofAustralian equities, Schroders:RETURNS in the Australian mar-ket have been solid in the pastyear, driven significantly by re-rating rather than earnings gains.

We see the market as fairlyvalued at present, although this isin the context of a bond marketwhich is aggressively valued byhistorical standards.

As with markets offshore, oneof the dominant drivers of theAustralian markets is the scarcityof return available from otherassets and the pressure on inves-tors to seek return by moving fur-ther along the risk spectrum.

Almost all major markets sawstrong returns in equities andbonds in 2012; this is highly un-likely to recur in 2013.

Paul Cuddy, CEO, BennelongInvestment Partners:THERE are several reasons whyAustralian equities could post a2013 return above 2012.

The rate and magnitude ofearnings downgrades appears tobe slowing. While we acknowl-edge there are still pockets of earn-ings risk, the earnings downgradecycle that began in 2008 is startingto improve.

Fears of a GFC-like downturndid not eventuate in 2012. In fact,global industrial production andworld-traded exports posted posi-tive growth. While 2012 wascharacterised by negative newsout of the US, China and Europecould possibly see synchronisedpositive news (or less negativenews).

There is a significant amount ofstimulus weighing into the globaleconomy. Central banks in the US,Europe, UK, Japan and elsewherehave committed to injecting largeamounts of liquidity into the glo-bal financial system.

These amounts dwarf what wasseen in 2008-09. In Australia, theRBA has already cut rates by 1.75per cent over the past 15 months,which should be positive for con-sumers and businesses in 2013.

Australian term deposits havedoubled since the GFC to morethan $500 billion. Over the sameperiod, the return on these depos-its has fallen drastically.

Interestingly, the dividendyield on the S&P/ASX 300 is nowabove the yield on Aussie 10-yearbonds for the first time in morethan 50 years.

Winston Sammut, CEO, MaximAsset Management:IN 2013, the problems in theeurozone are expected to continueto have an impact on markets, sowhile we do not expect to experi-ence an Armageddon we are likelyto experience ongoing volatility.

This and other global economicissues, including a slowingChinese economy, will likely capthe upside for our market.

We expect the 2013 year to endabout 5 per cent higher than its2012 close and that most of that

upside will come from the incomestream (yield) generated frombeing invested in equities. Our ex-pectations for the S&P/ASX 200Index are for a range in 2013between 4650 and 4850.

Andrew West, portfolio man-ager at Regal Funds Manage-ment:REGAL was on the bullish side ofopiniongoing into2012drivenbyaview global economic tail riskswould eventually recede and helplift the market in the back half ofthe year.

This view was primarily a re-flection of the market’s depressedearnings multiples in December2011 and the likelihood of multipleexpansion, even while underlyingearnings for corporate Australiawere likely to be flat.

While this view played out gen-erally, we did witness a sharp slow-down in the mining sector that willcontinue to be felt over comingperiods. So we start 2013 with amore cautious view.

A further reduction in forwardearnings expectations is expectedas the Australian economy slowsdue to the slowdown in the mininginvestment cycle, but we are un-likely to benefit again from themassive quantitative easing pro-grams announced in the US andEurope that were instrumental indriving up multiples worldwide.

We expect slowly increasingdomestic unemployment due tothe slowdown in mining invest-ment, and when we look at pastcycles over the past 30 years, theseperiods are usuallyassociated withpoor stock returns.

In the current cycle, however,the economies of many of ourtrading partners, such as Chinaand the US, look to be improvingand this will help limit downside.

Equity valuations, while cheapversus bonds, are fair value onmost earnings measures but earn-ings growth relative to history islacking.

Collectively, this leads us to ex-pect the market to be broadly flatby the end of 2013.

However, within this we antici-pate greater dispersion of returnsamong stocks than was experi-enced in 2012, so stock picking willbe paramount. As a hedge fundmanager we expect to generatehalf our alpha from the short sidein this sort of market, which will bea differentiating factor.

Erik Metanomski, director,Lanyon Asset Management:AT Lanyon, we never reallyconsider or discuss the index butrather focus on the metrics andfundamentals applicable to indi-vidual companies.

Having said that, we believethere may well be further down-ward interest rate pressure in Aus-tralia during 2013. Historically,this has generally been bullish forsharemarkets, with Japan over thepast 20 years or so being a notableexception.

It follows that any further re-duction in interest rates may in-tensify the already frenetic ob-session with chasing yield in orderto maintain incomes and real ratesof return.

While this would be a totallyunderstandable response, it bringswith it the danger of paying toomuch for certain assets which maynot end upproducing the certaintyor consistency of income thatinvestors assume to be a given.

An acute focus on selectivitywill be the key but we fear the risk/return balance is already becom-ing challenged in many instances.

History abounds in horrorstories of severe capital loss associ-ated with periods characterised byincome obsession. So while thechase for yield is likely to continuein the near term and could be quitebullish for the local sharemarket,this also needs to be tempered byan awareness of the highly un-stable and potentially damagingcharacteristics still very apparentthroughout the Western and de-veloping world.

A theme we feel could receive agreat deal of attention in 2013 isthe likelihood of elevated tensionsin currency markets as so manycountries race to devalue by what-ever means necessary in order tobecome more competitive.

This is a zero sum game which,coupled with a potential movetowards more widespread protec-tionism, could end up as the greatwild card for sharemarkets in 2013.

Our dollar’s been above US dollarparity for almost all of 2012. Mostpeople believe it’s overvalued butthere’s notmuch happening inter-nationally to bring it down. Mightthat change in 2013?

Matt Sherwood:EXCHANGE rates are relativeconcepts and Australian funda-mentals haven’t changed muchsince 2009, whereas the rest of theworld has deteriorated.

For a second year running, theAustralian dollar remained aboveparity, even though commodityprices and interest rate differen-tials decreased in 2012, indicatingour currency is no longerdriven bythese forces, but by capital flowsinto Australia.

Capital inflows are unlikely tocease in 2013 as Australia is one ofonly seven countries with a AAAcredit rating.

With a stable outlook, and theyield premium on our equities andbonds, it ensures constant foreigndemand.

Since the end of 2007, 89 percent of bonds issued by the federalgovernment have been bought byforeign investors, driving the ex-change rate up in the process.

Even if the RBA cut rates furth-er (as it should) and commodityprices decline a bit more, the Aus-tralian currency is likely to remainabove parity.

This is not the new norm, butthe old norm, where the Austra-lian dollar had been above parityfor 83of theyears sinceFederationin 1901.

Andrew Fleming:AS fundamental investors, wehave been expecting the dollar totrade back towards fair value.

This expectation has clearlyproven incorrect.

Fundamentals remain over-shadowed by a global landscapecharacterised by central bank in-tervention, which is forcing inter-est rates and currencies to departsignificantly from the levels thatwould be seen in a free market en-vironment.

While the RBA aims to set pol-icy sensibly in relation to domesticconditions, it is powerless againstoffshore central banks using arti-ficially low interest rates as thepanacea for previous policy errors.

Although the intentions ofpolicymakers to continue on thepath of extreme manipulationhave been made clear, if successfulthis will see the $A continue totrade well above fair value. Wemaintain the inability of policy-makers to suppress market forcesindefinitely will drive the $A backtowards fair value (lower than$US0.80) in the long run.

Paul Cuddy:TRADITIONALcurrencymodelstypically link the $A to interestrate differentials and commodityprice changes.

However, the emerging key tocurrency price movements is thecredit rating and relative attract-iveness of sovereign bonds.

While the $A may seem ex-pensive on many traditional mea-sures, it is possible that it will re-main at or above parity to the $USfor some time.

Many currency forecastersunderestimated the impact of S&Pdowngrading its long-term creditrating on the US to below AAA,while Australia was one of a smallgroup to retain its AAA rating.This has resulted in many foreigngovernments and institutions in-creasing $A buying.

This could continue as long asthere is a credit rating differentialand US and European bonds con-tinue to struggle under the weightof various domestic issues. Oncethese issues start reversing, and in-terest rate and credit rating differ-entials unwind, the $A will easeback.

Winston Sammut:NOTWITHSTANDING the factwe have had a number of interestrate easings in 2012, resulting in acash rate at year’s end of 3 per centand likely to go lower early in 2013,even at this level our interest rateswill persist in remaining attractiveto offshore investors.

Coupled with a sound, albeitlower, outlook for growth in Asia,investments in Australia will likelycontinue to offer global investorsgood cause to buy/support ourcurrency.

Accordingly, we do not expectmuch downside for the Aussie in2013 with a trading range between$US1 and $US1.10 the most likely.

Andrew West:UNDER normal circumstanceswe would expect the current inter-est rate reductions being im-plemented in Australia, coupledwith the fall in Australia’s terms oftrade, to have already put down-ward pressure on the dollar.

However, this time US monet-ary policy has been an evengreater influence since the globalfinancial crisis due to the scale ofquantitative easing undertaken.

The US Federal Reserve has re-cently articulated both unemploy-ment and inflation criteria aroundits accommodative policies.

So unless these criteria are metandtheytriggera tighteningphaseor conversely there is a sharpgrowth scare in Australia, it is diffi-cult to forecast a significantlylower dollar at this stage. We also

need to consider the implicationsof the recent change in leadershipin Japan on the Australian dollarwith the LDP signalling an inten-tion to support its own large-scalequantitative easing programthere.

This may also act to limit anyfalls in the Australian dollar as oureconomy may attract a dispro-portionate flow of funds that exitthe yen in the face of this rhetoric.

Erik Metanomski:THE Australian dollar has beensupported in recent years by ourhighly positive interest rate differ-ential with the rest of the worldtogether with our relatively strongfiscal budgetary position; the im-pact of an unprecedented resourceboom;and thestrengthof our localbanking sector.

Given the very limited likeli-hood of an outbreak of inflation-ary pressures in the near term(next 12 months) either here or inthe major advanced economies, itis quite conceivable the $A couldremain quite elevated during 2013.

What’s likely to happen to theRBA official interest rate?

Matt Sherwood:FOR 10 years, Australia has beenriding the coat-tails of Chinathrough high commodity pricesand a record mining investmentboom (which shielded Australiafrom the worst of the post-GFCworld).

This boom will peak within afew months and then progress-ively lessen and the RBA has beeneasing official interest rates for 14months to stimulate the non-mining economy.

However, Australian growthcontinues to moderate as financialconditions remain tight (due to thestrong Australian dollar). House-holds continue to de-leverage andstate and federal governments im-plement austerity policies at theworst point of the cycle.

Consequently, the entire policyresponse falls on the RBA, whichwill need to cut rates aggressively-to stabilise the growth outlook.

The target cash rate is likely tobe cut from 3 per cent to 2.25 percent, after which real deposit rateswill be negative and banks will bereluctant to pass on further ratedecreases to borrowers and de-posit holders — confirming thatmonetary policy is less effective ina de-leveraging environment.

Andrew Fleming:THE RBA official cash rate is like-ly to drop in 2013, with our fixed-interest team thinking this will beanother 50 points to bring it to 2.5per cent.

While we see little prospect foractivity surprising to the upsidethrough an election year and amidongoing global de-leveraging —prima facie suggesting a case canbe made for rates to go even lower— we also expect the RBA to wantto maintain some policy flexibilityshould the need arise as the econ-omy continues to slow into 2014.

Paul Cuddy:RATES will fall further in 2013 ifinflation remains within the RBAtarget range and the terms of tradecontinues to deteriorate while thenon-resource economy continuesto experience soft demandconditions.

The RBA is acutely aware ofconsumer and business reluctanceto re-leverage at the same timethat the big banks have decided tonot pass on the full rate cuts.

The RBA maintains it focuseson inflation and encouraging sus-tainable growth.

While the RBA does not steerpolicy to a currency target, it isvery much aware of the adverseramifications of a higher $A on thebroader economy.

We have already seen officialrates cut from 4.75 per cent in Sep-tember 2011 to 3 per cent inDecember, back to where theywere in late 2009 at the depths ofthe GFC.

This means the central bankershave cause to believe that inflationrisks are receding while there arestill risks to economic growth.

Policymakers will be most in-terested in how the non-miningeconomy performs, particularly asthe mining-related sectors con-tinue to slow.

Winston Sammut:CONSUMER confidence hasstayed low amid concerns includ-ing a slowing Australian economyand job security, a slowing Asian(Chinese) economy and adisjointed Europe.

This year will also see a federalelection, which tends to lowerconfidence.

Accordingly, weexpect anotherround of easing will take place(two cuts of 25 basis points each bymid-year) to a cash rate of 2.5 percent.

At this level, any upward pres-sure on the currency should ease.

Andrew West:WITH unemployment likely toclimb due to the mining slow-down, inflation remaining low, thebanks still resisting passing on thefull amount of past rate cuts andconsumers firmly preferring sav-ing over spending, we see the RBAcontinuing to cut interest rates in2013.

The objective of these cuts is tostimulate consumer spending andnon-mining business investmentto replace the significant contri-bution the mining sector made toGDP growth over the past fewyears.

However, in working out howfar rates might fall, asset prices,particularly house prices, warrantscrutiny.

The RBA will likely be con-cerned that when measuredagainst average incomes, Austra-lian house prices are already atlevels that have caused problemsin other developed economies.

For this reason, we believe theRBA faces a delicate balancing actand may possibly be slower inmaking cuts than some in themarket expect.

Erik Metanomski:INTEREST rates may well remainunder pressure due to the high $Aas well as the corresponding weak-ness in our manufacturing, retailand construction sectors.

What equity market sectors willyou be looking at closely — posi-tive or negative?

Matt Sherwood:RELATIVE stock performance in2012 has primarily reflected earn-ings delivery, yield and incomegrowth.

In 2013, the environment willlikely be characterised by soften-ing domestic growth, above-average valuations and onlymodest overall stimulus.

Accordingly, it is hard to see thedominance of yield and incomegrowth diminishing, particularlywith lower domestic interest rates.

This year will witness a con-stant battle between lower interestrates and a weakening domesticeconomy and the stronger of thesetwo forces will determine marketreturns.

The likely mixed investmentperformance will be ideal forskilled stock pickers while com-panies exposed to the improve-ment in the US and China econ-omies, and which have potentialmargin expansion, are well placedto outperform.

With this in mind, firms withstrong balance sheets and robustoperating models, and whosemanagement and boards knowhow to reinvest profits wisely, arelikely to find favour with return-hungry investors.

Andrew Fleming:AS always, our views on stocks aredriven by stock-specific ratherthan sectoral factors.

For example, within resources,the value that we see in the major

miners is rarely apparent in thehigher-cost, lower-qualitysecond- and third-tier miners. If,however, we were to look by sector— as contrarians we tend to findmore selective appeal in those sec-tors that have done poorly — suchas materials and energy, than inthose sectors that have done verywell, such as telecommunicationsand property.

Paul Cuddy:IN 2012, investors were rewardedfor investing in themes accordingto the extremely volatile macro-economic conditions.

In 2013, as the macro-economicconditions potentially stabilise, weexpect investors will be morefocused on bottom-up fundamen-tals rather than trying to second-guess macro changes.

It is potentially dangerous to in-vest on broad themes such as ratecuts and/or $A falls, particularly ifthere are stock-specific issues thatmore than offset the expectedbenefits.

We likehigh-quality stocks thatcan deliver positive earnings sur-prises, relative to expectations,which are inexpensive and are lesseconomically sensitive.

We like healthcare, retailing,leisure and some internationalearners.

In contrast, we are cautious onsome of the defensive stockswhich are expensive, includingtelcos, utilities and banks.

Winston Sammut:GIVEN the state of the globaleconomy (European problems,slowing Asia and a slow albeit im-proving US economy), we expectoverall growth prospects will re-main low for some time.

Weare talking in termsofyears,not months, for this scenario to re-main in place; i.e. at least five years,ifnot longer.Accordingly, investorfocus should be on income-producing assets.

With regards to the outlook forspecific sectors, we are stickingwith telecommunications (readTelstra) and the banking sectorwith their fully franked dividends.While 2012 was a stellar year forthe A-REIT sector returningabout 25 per cent, given our viewthe cash rate will continue to fall,yields on offer from investment inthis sector will compare mostfavourably with other invest-ments.

We are forecasting a total re-turn of about 10 per cent from theA-REIT sector for 2013, made upof about 7 per cent in income and amodest 2 to 3 per cent in growth.

Andrew West:WE believe that many bond prox-ies with good yields such asutilities, infrastructure and evenREITS can continue to out-perform in the declining interestrate environment we predict for2013.

Some financials will also ben-efit from this search for yield de-spite offering limited earningsgrowth. For the most part, how-ever,we believe investors willneedto have a strong stock-specific fo-cus considering the economicheadwinds.

We see good opportunities insome beaten-down companiesthat are embarking on aggressiverestructuring activities ahead oftheir peers. We see corporate ac-tions gradually increasing withboards being more willing to en-tertain selling assets; so that look-ing for value within individualparts of businesses is becomingmore effective than it has been forthe past few years.

However, we think conditionsin 2013 will test the sustainabilityof corporate dividendyields and sowe caution against blindly chasingthis factor considering wheresome yield-offering valuationshave reached. As an investor withthe ability to short stocks, we arealso focussed on identifyingstretched valuations or unrealisticexpectations in the market.

Sectors exposed to mining in-vestment face a difficult year withearnings downgrades likely tocontinue, particularly amongmany engineering companies.Building material stocks have ral-lied strongly as interest rates havebeen cut but we believe earningsexpectations will prove toodifficult to achieve given evidencethis is not proving to be a normalhousing cycle.

Additionally, some weak bal-ance sheets in this sector mayultimately be exposed. We also seea tough year for areas of retail de-spite the interest rate cuts.

Erik Metanomski:WE will look in a pretty non-discriminatory way at any sectoror individual company that throwsup a cheap and quality oppor-tunity for purchase at any giventime. As always, the focus will beon structural challenges, the com-pany or sector’s competitive pos-ition, quality of management,strength of balance sheet, freecash-flow generation and, mostimportantly, the price at which anindividual security can be pur-chased relative to our appraisedvalue.

BUSINESS 25THE WEEKEND AUSTRALIAN, JANUARY 5-6, 2013www.theaustralian.com.au/business