The Australian sharemarket is at an interesting crossroad. It has risen 2.3 per cent over the first half of the year, supported by myriad tailwinds including better than expected economic growth, falling inflation, expectations for rate cuts and resilient corporate profits.
To say that the market has climbed a wall of worry and gone against consensus expectations is an understatement. For most of the year, the macroeconomic narrative has pushed the view that equities have increasingly diverged from fundamentals.
We came into the year positive on equities, and we were happy to push back on a cautious consensus view whenever it became too loud. We have been fortunate that the market has moved in our favour through the first half, but where does it go over the next six months? And, what should investors do?
Any price weakness should be used to reset exposures for the next economic upswing and rate-cutting cycle. Picture: Bloomberg
We don’t want to mince words, and so we will state clearly and categorically that we remain positive on the outlook for equities.
Traditionally, the sharemarket rallies ahead of the economy during major turning points. Although the timing and magnitude of this divergence will vary, and is often determined by when policy support emerges, we don’t think the current episode is out of the ordinary.
There are several factors that continue to support our positive view and explain why the downside risks are more tactical (or short-term) in nature.
For those investors who might have been chasing the equity market higher through the first half, and who never managed to get ahead of the rally because of lingering growth, inflation, and interest rate concerns, they should be using any price weakness to reset exposures for the next economic upswing and rate cutting cycle.
At a global level, the economic cycle is now bottoming and will gradually pick up, led by the US, China, and Japan. Domestically, we think Australia is set to lag this upswing but only by a few quarters.
And although a shallow slowdown because of rising interest rates has been a blessing, shallow slowdowns also mean shallow recoveries and so expectations should be calibrated for this growth trajectory which will be modest versus historical norms.
While there is an intense focus on the path of interest rates, investors should step back from the noise of trying to second-guess central banks, particularly the Reserve Bank of Australia.
Instead, they should focus on broad macroeconomic trends over the coming 12 months. We expect both global and domestic economic growth will be stronger, inflation will be lower, key input costs will continue to decline and so too will rates.
These are all very positive developments vis-a-vis the bearish views that were pervasive just six to 12 months earlier and will allow corporates that have been able to control costs (and profit margins) an enormous amount of earnings leverage as sales improve.
In fact, what no one is yet talking about is how leveraged Australian corporates are to an improving economy, particularly with profit margins so resilient to negative developments post COVID-19.
‘Too optimistic’
This is always an underappreciated driver of earnings when the cycle turns because there is fear of being too optimistic when the market is jittery. As a result, there tends to be a rush of upgrades when sentiment turns. While this is still some way off, it is the next step in the evolution of the market cycle.
As a final comment on Australian inflation, our view is based on price pressures returning to the “neighbourhood” of the RBA’s target range (2-3 per cent) in 2025. We aren’t particularly worried about sticky inflation for the equity outlook.
We’d prefer if inflation was lower, but we don’t see a level around 4 per cent as a major impediment to the equity market tracking higher. Historically, the best periods for equity markets are when there is a little bit of inflation, so if the resting rate is a little higher than the post global financial crisis years, we’ll take that.
This column would be incomplete if we didn’t mention the political and social crosscurrents. Obviously, they can be highly destabilising for markets, particularly when there isn’t much valuation cushion built in. But markets have become better at isolating the impacts and assessing whether they are idiosyncratic or systemic.
That might not always be the case, but rather than live in fear, being diversified across the equity market and being prepared to adjust when conditions require, is a better approach for investors who don’t want to be caught short on the sidelines.
And so, the macroeconomic backdrop will continue to improve as we move into the second half and beyond. The start of the rate-cut cycle will support a new economic upswing that will broaden equity stock performance into cyclical and rate-sensitive areas of the market and give a boost to laggard value stocks and small caps.
However, shallow downturns that drive shallow upswings mean investors cannot set and forget into cyclically sensitive areas. Investing over the coming six months will remain difficult as we go through the final stages of the slowdown/consolidation, but this is when committed investors can also find stocks that are not yet priced for an improving backdrop in the bargain bin.
This article was originally posted by The Australian Financial Review here.
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