Themes For February

Following the strong returns recorded last month, equities consolidated during February with most global markets posting flat to slightly negative returns. The Australian market fell 2.4% primarily driven by weakness in mining stocks which fell 7.5% due to weaker commodity prices. The US market also fell by 2.4% with higher real bond yields placing pressure on equity valuations.

European markets fared a little bit better with both the UK and Europe posting modest positive returns for the month while China gave back almost all its COVID reopening driven gains from last month. Despite recent optimism that inflation had passed its peak, inflation data printed stubbornly high in February which resulted in a more hawkish outlook for interest rates. This pushed 10-year government bond yields in both the US and Australia up by over 30 basis points. As expected, the RBA increased cash rates by 25 basis points to take the total increase over the last 12 months to 325 basis points compared to 450 basis points by the more hawkish US Fed which drove the $US 4% higher against the $A.


Earnings (as always) remain the key

 Following a disappointing year in 2022, equity investors are eager to see share markets once again deliver the superior returns they are accustomed to. While interest rates play a role in determining market valuations, our philosophy is that over the long term, growth in company earnings is the principal driver of share prices. To this end, the trend of negative earnings revisions for 2023 in both Australia and global markets remains the dominant factor constraining our willingness to take on additional equity risk. In this environment it is difficult to trust valuations when the P/E ratio denominator is falling away.

With interest rates tightening in all developed economies in 2022, it is unclear to what extent the slowdown in economic activity in the current calendar year will impact on company earnings. Recent company reporting seasons for Q4 2022 in the US and for the December half in Australia, were lack lustre with minimal earnings per share growth followed by a slew of negative revisions to forward estimates. Applying revised earnings expectations to current prices gives a market valuation of around 18 times which is reasonable but not compelling value.

In addition to this, cash rates are likely to rise further, and longer bond yields remain uncomfortably elevated reflecting uncertainty about the prospects for inflation for the rest of the year. As we foreshadowed in late 2021, once higher inflation expectations become embedded in pricing behaviour and wage demands, inflation becomes self-fulfilling and requires more drastic action by central banks. Absent a severe recession, this is a drawn-out process with long and variable lags between the application of high interest rates and their impact on the economy – making it very difficult to determine exactly how far cash rates need to rise before demand is sufficiently moderated. In recent times the US Fed has indicated they will be much more hawkish on interest rates than previously expected preferring to run the risk of doing too much rather than too little to stamp out inflation. By contrast the RBA in Australia has said that it may even pause its tightening schedule in the near term to assess the impact of last year’s increases on domestic economic activity.

Strategy and Outlook

For quite some time we have a held a preference for global equities over Australian equities in multi-asset portfolios on the basis that there is a much greater opportunity to invest in high class companies in growth industries. Our market is relatively concentrated in a couple of major sectors particularly resources and banks compared to global markets. The Australian market tends to come into its own when global commodity prices rise given that Australia has the world’s leading resource companies, particularly in the iron ore, coal, and precious metals sectors.

With the recent reopening of the Chinese economy following a long period of COVID restrictions, the nascent recovery in the Chinese economy will be positive for steelmaking bulk commodities. While this has a direct impact on commodity exporters, it also has a flow-on effect to the broader Australian economy from an improvement in the terms of trade (the ratio of export prices to import prices) which will benefit GDP and improve the budget balance by up to $20 billion in the current financial year.

Because of this shift in fundamentals, we have decided to modestly re-weight some exposure from international equities to Australian equities while maintaining a constant level of equity risk across portfolios. While this is only a moderate adjustment, it is justified based on a divergence in fundamentals between Australia and global markets.