After surging by 6.3% in the month of July, the benchmark S&P/ASX 200 index drifted down 2.3% over August. Since the start of the new financial year, the index has risen 3.8%.

The August reporting season was fairly mixed, with earnings falling for the second consecutive year driven by the fall in resource company profits. Other sectors that displayed weakness were insurance, media, telecoms and the banks.

The parts of the economy supported by debt and immigration performed well, such as residential housing and discretionary retail, suggesting any expectation of a consumer downturn has been pushed out a little. Given the high level of household indebtedness, the possibility of further strength in consumer spending appears limited. There are risks to FY17 growth forecasts because revenue growth is expected to remain modest and retail competition more intense.

While earnings growth has proved difficult, Australian corporates have focused on improving cash generation. Industrials and the resources sector have generated improved cash flow through better working capital management and also by reducing capital expenditure.

Many companies with domestic earnings showed that household consumption is still reasonably strong, where it can be supported by debt and immigration.

The wealth effect created by higher property prices has supported discretionary retailers, such as JB Hi-Fi, Harvey Norman, and Nick Scali, a furniture retailer operating mainly on the east coast of Australia, which posted 30% revenue growth. 

Other economically sensitive sectors did not perform as well. Real Estate Investment Trusts (REITS) demonstrated little income growth, with retail REITS highlighting subdued department store sales. Supermarkets suffered from deflation generally, particularly in fresh food, experiencing a fairly soft quarter. However, we are pleased by the turnaround signs at Woolworths.

The contrast between the East coast and West coast state economies was stark. For example, the property developer Stockland reported WA earnings down 22% year-on-year due to weak employment and falling migration, while in NSW earnings were up 186%.

The major banks continue to face a challenging revenue environment and high funding costs. Bad debts are creeping higher. Commonwealth Bank flagged a 23% increase in bad debts, while Westpac cited a lack of institutional demand for credit and rising bad debts. To compensate these headwinds, the major focus of the banking sector has been on taking costs out of the business.

The bounce in commodity prices, particularly iron ore and coal, has meant the expected restructure of the resource sector has been pushed out, with high cost producers such as Atlas surviving. Higher than expected commodity prices also helped companies such as Fortescue and Rio Tinto pay down debt.

This earnings season demonstrated exposure to the “silver dollar” of the ageing baby boomer demographic is attractive from an investment perspective. Hospital operators Healthscope and Ramsay Healthcare reported strong results and they expect further growth in the coming year helped by new bed openings.

On the macro front, the US economy continues to demonstrate momentum with strength in employment, services inflation and retail sales. The probability of rate rises continues to increase and the Federal Reserve has made comments preparing investors for another rate increase. We have been encouraged by the underlying strength of many Australian companies’ offshore earnings, such as Brambles, Cochlear, News Corporation and James Hardie.

This recent reporting season has strengthened our view that our Australian equity portfolio should be positioned for:

1. Some weakness in the domestic economy;
2. Continued improvement in the US economy; and
3. Exposure to the “silver dollar” - the ageing baby boomer demographic in Australia via hospitals and superannuation.