June 2022 / MARKET OUTLOOK
Australia: Midyear Market Outlook
Economies are transitioning from inflation to stagflation to economic slowdown.
- We have entered a more challenging investment environment where liquidity is being withdrawn as supply shocks increase, both in Australia and globally.
- We have increased our exposure to defensive growth, such as consumer staples and health care, funded from the more cyclical parts of the market.
- We think it is better to prepare for slowing growth and rising recession risk in 2023 rather than dwell on what stares us in the face today (higher inflation).
A More Challenging Global Economy
The key to understanding global equity markets in 2022 is that after unprecedented fiscal and monetary stimulus to counter the pandemic- induced recession of 2020, central banks and investors are faced with rising inflation that is at multi-decade highs. With hindsight, the stimulus and liquidity provision by central banks over the past two years has proved excessive and must now be curtailed. One global effect from the excess liquidity has been to inflate asset prices indiscriminately across all asset classes – bonds, credit, property and equities.
As major central banks abruptly reversed course and began to tighten monetary policies, the natural result has been to compress the rich valuations that arose at the height of the post-COVID liquidity boom. One common mistake by governments, investors and economists was to overfocus on global supply chain disruptions as the principal cause of rising inflation in 2021. On this view, inflation could be characterized as being transitory in nature and likely to unwind as supply chains normalized. Investors paid insufficient attention to the role of excess aggregate demand as a key factor behind supply bottlenecks leading to generalized inflation pressures that are unlikely to unwind without strong efforts by central banks.
It was a combination of global supply chain disruption due to the pandemic and excessive demand stimulus that are the root causes of today's inflation overshoot. The inflation overshoot and the need to counter it have been the defining features of financial markets in 2022, in our view. More recently, Russia's invasion of Ukraine has caused severe disruption in many commodity markets, notably energy and food. This led to sharp commodity price increases, creating problems for central banks as inflation pressures have increased further in the short term, even though commodity price hikes are ultimately demand deflationary.
The upshot is that we have entered a more challenging investment environment where liquidity is being rapidly withdrawn as supply shocks increase, both in Australia and globally. A growing risk for equity investors is that central bank rate hikes are primarily intended to reduce or slow growth in aggregate demand. This is the main channel through which monetary policy works, and there is always some risk that monetary policy gets tightened too much. When a number of major central banks need to raise policy rates simultaneously, this inevitably further increases recession risks. Few would disagree that policy tightening to counter inflation is the right course of action, but the requisite degree of tightening is hard to determine in advance. Of course, the Fed and other central banks will usually aim for a soft-landing, but achieving this is easier said than done. Figure 1 shows the Fed's track record in this respect: in 75% of rate hiking cycles since the 1950s, a U.S. recession has followed. Australia, as a small, open economy, was only able to avoid following suit in 3 out of the last 11 U.S. recessions. Currently, there is enough momentum from past stimulus to make a U.S. recession in 2022 a low probability outcome. But we see a strong possibility of a slowdown take hold or recession in 2023.
Big Picture Themes: Rising U.S. Recession Risk
(Fig. 1) Fed rate hiking cycles and US recessions
Australia's Domestic Outlook
Despite the Liberal government's achievements under Scott Morrison in successfully managing the impact of the pandemic on the economy, Australians voted for change, electing a Labor government under Anthony Albanese on May 21. Domestically, the new government faces the same challenges as the outgoing government of higher inflation and interest rates combined with signs of slowing economic activity and calls for deficit reduction.
Whilst the election result is not expected to have any direct impact on the RBA's monetary policy, there are emerging signs of growing wage pressure. Indeed the new Labor Government has backed a rise in the minimum wage at the same rate as inflation, which is currently 5.1%. This would be much higher than recent increases from the Fair Work Commission. The Fair Work Commission decision covers about 25% of the workforce with another 20% directly linked to this decision. The risk of wage-price spiral cannot be ignored by the RBA. Overall, we remain cautious about the outlook for the local economy, where we see a strong possibility of a slowdown taking hold or in a worst case a mild recession in 2023. We think the upside is that inflation should be easier to bring under control in Australia than in the U.S., as fiscal stimulus to fight the pandemic has been less excessive and better targeted. Ahead of the impending slowdown, we prefer to underweight sectors and industries that are most impacted by the recent spike in wage and price pressures, such as the banks, consumer discretionary, and retail sectors. From the second half of this year we expect corporate earnings to come under pressure as activity slows, which requires maintaining a defensive portfolio stance.
Big Picture Themes: Commodities Remain Well Supported
(Fig. 2) Largest commodity exports from Russia versus Australia
Investors to Focus More on Earnings
As 2022 unfolds, we believe the market is likely to worry more about a slowdown in global activity and thus increased earnings risk than about inflation and interest rates. Although low in absolute terms, Figure 3 shows that Australian equities in relative terms have outperformed other stock markets by a significant margin in the recent global correction. This is largely due to the greater resilience of consensus Australian earnings estimates, as shown in Figure 4, largely thanks to Australia’s exposure to resources. For the majority of countries, the 3-month EPS revision ratio is negative (the ratio measures the number of stocks for which consensus EPS estimate has risen in Forecast Year 1 and Forecast Year 2, versus the number of stocks for which it has fallen). This development is unsurprising, given the fact that a global interest rate upcycle is now underway.
Australian Equities: Relative Outperformance in 2022
(Fig. 3) Global equity index performance
Australia: Earnings Per Share Held Up Better Than Most
(Fig. 4) Earnings revisions by country (3-month revision ratio)
We believe that we are only in the early stages of a global earnings downgrade cycle, which is expected to intensify as recession fears increase. As 2022 progresses, the market will come to worry more about slowing growth than about inflation, and thus perceptions of earnings risk will likely increase. Australia's earnings revision ratio has so far held up much better than elsewhere thanks to its higher market weights for energy and commodities. Still positive 3-month earnings revisions have largely been driven by the resources sector, by miners, oil and gas. As global activity slows, earnings revisions for Australia are also expected to turn negative, as cyclical areas like consumer discretionary and media come under greater pressure in the second half of 2022. However, as a 'value' market with roughly 50% of market cap in value sectors like banks, miners and energy, Australia may continue to show some outperformance in relative terms, as earnings revisions deteriorate at an even faster pace in other markets.
Normally, we would see risks building for commodity prices as the world economy enters a slower growth environment in 2H 2022, particularly as China's short-term economic outlook has dimmed due to the lockdowns mandated by Beijing's adherence to a strict zero-COVID policy. However, the global slowdown in 2023 may be unusual in that Australia's key commodity prices may remain relatively well supported. The disruption caused by the west's sanctions on Russia are expected to intensify as Europe strives to phase out purchases of Russian oil and gas by year end, opening up the possibility of secondary sanctions on countries that since February have increased purchases of heavily discounted Russian oil (India and China). With OPEC so far refusing to increase output quotas, high energy prices, including coal, may persist into 2023. And China has not downgraded its 5.5% growth target for 2022, in which case it may double down on fiscal stimulus via infrastructure spending after the omicron wave has ended, aiming for a rapid rebound in economic activity in 2H. In that case, we might expect the price of iron ore – the single most important commodity price for Australia's terms of trade – to remain firm.
Market Outlook for 2H and 2023
In the recent global market correction, the U.S. fell by almost 19%, a similar decline to that of the MSCI AC World global stock index. On a relative valuation basis, the ASX 200 currently looks cheap. As a result, global money managers have been directing more money toward the Australian stock market. Australia's cheapness partly reflects its composition and the greater share of value sectors in the index. It also reflects the fact that the RBA was less enamored with QE (quantitative easing) policies after the global financial crisis and more recently in response to the coronavirus pandemic than either the U.S. or Europe. As a result, Australia has created less excess local liquidity to distort domestic equity valuations, driving them to levels that were historically rich relative to fundamentals.
We believe Australian stocks look set for further relative outperformance in the second half of the year. Australia will likely benefit from increased exports of liquid natural gas and coal to Europe due to tighter sanctions on Russian energy. At the same time, more fiscal stimulus to support growth in China could help to support the price of iron ore, even as the global economy slows. As in other developed markets, in Australia growth stocks have struggled year-to-date. But as the year unfolds and recession fears multiply, value stocks are likely to feel the most pressure. For 2022 overall, the relative performance between value and growth stocks may become more evenly balanced than it has been year- to-date. For the second half, we expect quality growth stocks to perform better in the face of a continuing earnings slide.
In terms of portfolio positioning, we have increased our exposure to defensive growth, such as consumer staples and health care, funded from the more cyclical parts of the market, including extreme growth where we remain cautious. Given our view that global monetary tightening will result in a cyclical recession in profits due to slowing activity, we retain the cautious stance in our portfolio first adopted over six months ago. We seek quality stocks that have good pricing power in the more defensive growth segments, such as Computershare, a provider of stock registration and transfer services that has delivered good exposure to rising interest rates. Besides share registry, Computershare is a global provider of services for employee equity plans, corporate trusts, stakeholder communications, and corporate governance.
As we expect the U.S. dollar to remain firm in 2022, we are positive toward the prospects for the dollar earners in our portfolio, companies such as ResMed and Aristocrat. We like certain metals including lithium and copper as electric vehicle (EV) plays. For example, Allkem possesses a globally significant, long-life, low-cost lithium asset that is leveraged to the growing demand for lithium-ion battery technology and energy storage. Among the miners we also like Rio Tinto, where a significant portion of revenues are tied to iron ore. We think Rio will likely be supported by improved stability in the Chinese property market and significant additional stimulus in the form of infrastructure investment. In contrast, we remain very underweight Australian banks. Their earnings may look reasonable now, but they have the potential to weaken sharply in 6 to 12 months' time when rising non- performing loans as a result of slower growth outweigh the benefits of wider net interest margins.
Australia Valuations Appear Attractive Globally
(Fig. 5) S&P/ASX 200 next twelve months P/E ratio
Recently we have taken the opportunity to add to growth companies that we believe had become oversold based on near-term inflation fears and higher projected interest rates. In this category of oversold growth names we include Carsales, the dominant automotive online classifieds business which in our view possesses a durable business model and good pricing power. We expect quality growth stocks to come back into favor later in 2022 as policy rates stabilize and long term yields decline. Having reduced exposure to many of these growth companies in 2021, we have considerable scope to take positions higher. In our view, this could help the portfolio to strive to perform well as markets move beyond their current inflation and interest rate fears to refocus on the issue of slowing growth, both domestically and globally. After a period of stagflation, we believe recession risks will come to dominate equity markets in 2023. We believe it is better to prepare for what is likely to come in 2023 (slowing growth and rising recession risks) rather than to dwell on what stares us in the face today (higher inflation).
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