Our outlook and sector view for Australian equities
Overview
The S&P/ASX 200 Total Return Index returned 9.4% over the three months and -1.1% over the year to 31 December 2022.
S&P/ASX 200 Accumulation Index cumulative return (Dec-21 to Dec-22)
Source: S&P, Bloomberg
Outlook
Recommendation: Maintain underweight.
Australian equities are facing a period of significant uncertainty and a weaker global economic backdrop. While valuations are not necessarily unattractive, we believe there is meaningful scope for earnings downgrades in the months ahead. Current valuations look attractive but in reality, this is more akin to a “calm before the storm” moment with further downgrades still to come in our view. We have already begun to see this with some businesses such as Domain Group downgrading off the back of a slowing property market.
The macro backdrop has worsened materially, especially globally. A weaker global economy and coronavirus challenges in China bodes poorly for resource demand and other cyclical sectors such as industrial businesses. Higher interest rates support bank revenues by raising margins on their loan books, but this can often be more than offset by higher bad debts and weaker credit growth. Consumer sentiment has also fallen sharply, which bodes poorly for the retail sector while business sentiment is also subdued, potentially weighing on investment spending.
In conclusion, risks remain elevated. The international commitment to further rate hikes increases the chance of a global recession with equities tending to fare poorly in that environment. Accordingly, we maintain our underweight recommendation on the Australian sharemarket.
Sector view
Our outlook for some of the major sectors of the S&P/ASX 200 is as follows:
Banks
Recommendation: Maintain underweight.
Our outlook for the banking sector rests on four key areas:
- How are net interest margins (the return earned on bank assets less the cost of funding these) trending?
- What are the overall prospects for credit growth?
- Our view on bank underwriting quality i.e. are they going to be writing off loans as bad debts?
- The trend in bank operating efficiency.
On the positive side of the ledger, bad debts are at extremely low levels with the RBA and major banks reiterating the strength of credit quality at present. This is beginning to shift with mortgage stress beginning to rise from very low levels according to recent Roy Morgan surveys as illustrated in the below chart.
Roy Morgan Survey – Mortgage Stress for Owner-Occupied homeowners (Jul-07 to Oct-22)
Source: Roy Morgan
The picture for bank operating efficiency matters more outside of turning points where rising credit risk is not a factor as it is today.
Net interest margins are also trending higher in the wake of the RBA interest rate hikes. An important drag on margin expansion is the maturity of many fixed-rate loans which are still trending well above historic averages as a share of the market. As borrowers face a material shock in reverting from artificially low fixed rates to much higher rate options, we expect refinancing demand to remain elevated as they look for better deals. This will curtail margins as banks compete to maintain market share. In their latest update for October the Australian Bureau of Statistics (ABS) noted that refinancing activity remains at record highs[1].
Lastly. the economic backdrop is softening from admittedly high levels. Annual economic growth of 5.9% in the September quarter is likely to be the peak growth rate we see for some time. Consensus forecasts see economic growth slowing below trend (long term average ~2.7%) for the next two years, a rate consistent with weaker credit growth and also one where loan arrears may rise, reducing profits due to rising losses. We believe the downside risks are currently outweighing potential upside factors and we retain an underweight position on the banking sector.
Resources
Recommendation: Maintain underweight.
Iron ore prices have spiked dramatically in the December quarter (up 12.5% quarter-to-date) compared to flat performance in broader commodities with the Bloomberg Commodity Index only up 0.7% over the same period[2]. A key driver of iron ore’s relative outperformance was China exiting its restrictive “Zero Covid” policies with heightened expectation of renewed property and infrastructure investment driving iron ore demand.
We believe this price speculation is potentially premature with weakness from countries outside China a more pressing concern for us. While China is a major source of commodity consumption it is difficult to have a materially positive view if demand from the rest of the world is contracting. To illustrate, the below chart captures activity by steel using businesses across major regions. Readings below 50, which is the case for all major regions, signal contraction. This will likely detract from resource demand suggesting that the bounce in mining stocks for the quarter may not last.
Steel Users PMI by region[3]
Source: S&P Global
Demand destruction due to rate hikes in the US and elsewhere as well as soaring energy prices in Europe remain an ongoing concern. We can see this depicted below in forecasts of global industrial production with growth over the year expected to be limited in both the US and Eurozone, a decidedly negative prospect for resource demand. The bounce back anticipated for China remains an inadequate offset in our view.
Industrial production – actual and forecast for major countries (2021 to 2024)
Source: Bloomberg
Taken together we believe the material headwinds to global growth will outweigh potential positives from a “China reopening” narrative and maintain our resource sector underweight. We do acknowledge that the sector is notoriously sensitive to China speculation which can trigger spurts of temporary outperformance before prices revert, the final chart is a reminder of this and how far the sector (in blue) can rise or fall relative to Chinese economic fundamentals (in black).
China annual economic growth versus annual growth return for the Resource sector (2007 to 2022)
Source: Bloomberg
Retail
Recommendation: Maintain underweight.
Spending has shifted firmly from goods to services with the former growing 9.4% for the year to October 2022 versus 34% growth for the latter over the same period. These growth rates are distorted by the impact of East Coast lockdowns last year which depressed services spending in particular. Both types of consumption appear to have seen growth rates peak with a poorer outlook on the back of weak sentiment.
Annual household spending growth split by goods and services (Jan-20 to Oct-22)
Consumer sentiment has fallen and a more refined measure of spending intentions (based on credit card data) has also softened markedly. The CommBank HSI is correlated with real consumption spending (a measure that strips out price impacts to assess underlying demand). Current levels suggest a material softening during the December quarter. We have arguably begun to see this in two ways;
- Underlying retail sales only grew 0.2% for the September quarter, a level last seen prior to the coronavirus pandemic when economic growth was subdued; and
- October retail sales fell 0.2% from September levels.
Annual growth in real household spending versus Spending Intentions Index (Sep-18 to Dec-22)
Source: Bloomberg
Lastly household savings were 6.9% for the September quarter, a level last seen prior to the pandemic when economic growth was below trend (long-term average for our economy). In addition, the majority of fixed rate mortgages taken out during the pandemic will expire in the next 18 months and will act as a drain on household spending.
Overall, we believe meaningful drags on consumer spending are beginning to emerge. This will bode poorly for the retail sector after recent years of above-average profits (boosted by government stimulus programs) with a return to pre-pandemic profitability likely to be accompanied by further share price weakness.
Australian Real Estate Investment Trusts (AREITs)
Recommendation: Downgrade to underweight.
The AREIT universe outperformed the broader market in the December quarter. Part of this was a rally in response to falling long-term bond yields. AREITs are often treated as bond substitutes due to their high distribution yields. As such, when bond yields fall, we typically see strength in AREIT prices as they become a more attractive alternative and attract investor interest. A-REIT valuations remain below peak levels with most trading at material discounts to their reported book value (property and other asset values minus liabilities such as debt).
This view presumes that the valuations underpinning the book value are reasonable. We think that there is room for doubt with capitalisation (or “cap”) rates still trading at record lows for some sectors, particularly industrial property as shown below.
Property capitalisation rates by sector (Oct-12 to Oct-22)
Source: Bloomberg
The above cap rates still fail to capture the lift in market interest rates since the pandemic began with the 10-year bond yield rising over 3% from its recent lows in February 2020. This increase in market interest rates means higher financing costs, reducing profits and ultimately distributions. In addition, commercial real estate does not trade in a vacuum. Higher rates have already impacted bond prices, prompting the biggest correction in decades. They have also started to negatively affect residential property prices and a similar effect is anticipated for the commercial property market in our view.
A-REITs enjoyed a bounce in performance since the end of September, but we see this as unlikely to persist in the near-term given the above factors. Accordingly, we downgrade our view from neutral to underweight the sector.
