The Australian market touched fresh all-time highs last week, although the local market has lagged the performance of global equity markets so far this year.
This continues a trend that has been in place for much of the past 10 years.
Renewed optimism towards interest rate cuts from the Fed has provided an additional boost to equity markets in recent weeks. Hopes for US rate cuts fell drastically earlier this year, after inflation data came in stronger than expected for the opening months of 2024. US inflation has turned down again, however, driving renewed confidence that the Fed will soon reduce rates. A rate cut is now fully priced in for September, with nearly three cuts priced in by year end. This follows cuts in Switzerland, Sweden, Canada and Europe in recent months.
Lower interest rates offer the prospect of better global growth in 2025, as well as helping to improve share market valuations against interest rate benchmarks. This has further boosted global equities and pulled Australian equities higher, despite less positive news recently on local inflation.
Australian Earnings Stuck in the Slow Lane
Australia’s sector mix has been a drag on relative performance, with information technology weighted at only 4%. Australia’s large resources sector (20% of market cap) has also been a poor performer year-to-date, as concerns around China’s commodity demand linger.
Australia’s sector mix is also dragging on earnings growth, with aggregate earnings contracting by -3% in FY24 followed by a relatively modest +6% rebound in FY25. This is significantly weaker than the low double-digit earnings growth expected in global equities. Resource sector earnings are currently declining and are the largest drag on aggregate earnings growth for the Australian market.
Aggregate Valuation Not Particularly Compelling
In terms of valuation, Australia is trading at a large PE discount to the US, but a premium to the rest of world and a premium to its own historical valuation level.
We don’t believe the valuation premium is small enough in itself to demand we take an explicitly negative view on the outlook for Australian equities, particularly given the fact that valuation is not a great market timing tool.
However, it is difficult to make a case that valuations are cheap. Strong multi-year returns typically come from cheap valuation levels. e.g. 2009, 2011, 2016 and 2020. Our 3-year return expectations for the Australian equity market are in the average to slightly below average zone.
Domestic Monetary Policy Cycle Less Supportive
From a 12-month perspective, Australia’s monetary policy cycle is also looking less favourable, with the residual risk of a near-term rate hike given stubborn domestic inflation. It is interesting that the market has faded the probability of a domestic hike in recent weeks, with this largely due to positive news around the US inflation cycle. While the market is reluctant to price in a hike, Australia’s policy rate is at a minimum expected to remain on hold until the middle of 2025. With the economy already in lacklustre condition, this poses some downside risks for FY25 earnings. However, expansionary fiscal policy through FY25 should cushion the economy and earnings cycle from a hard-landing scenario.
The Q2 CPI print due in late July will be pivotal for the RBA’s early August decision to hike or hold. We view it as a very close call. Our opinion is that the RBA is a reluctant hiker, so we stick to our on hold view, although quarterly inflation above 1% will likely force their hand. Even if the RBA does stick to its on hold stance, Australia is looking increasingly out of step with the global easing cycle.
Banks Overachieving Versus Subdued Growth Prospects
Despite the higher-for-longer interest rate narrative, the heavyweight bank sector has been surprisingly strong, outperforming the market significantly over the past year. Higher rates are, all things equal, good for bank margins, although the market seems to be underplaying the risk of lacklustre top-line growth, along with the risk of rising bad debts. Given increasingly stretched valuations, we remain underweight.
More broadly, the local August reporting season should highlight relatively subdued aggregate earnings conditions, albeit there will still be some bright spots in areas like healthcare, IT and insurance, as well as other selected global growers. We expect aggregate FY25 earnings growth expectations (+6%) to be reduced at the margin.
Global Trends Should Ultimately Drag Australia Higher by Year End
Overall, despite a relatively constructive global backdrop in terms of a US/global soft landing and broadening monetary easing cycle, it is likely to be difficult for the Australian market to push ahead decisively, given market growth prospects look constrained and aggregate valuations are not compelling.
Global equities are likely vulnerable to at least a short-term correction, or consolidation after a largely uninterrupted run. However, we still see the supportive macro backdrop as likely leading to a rising trend over the second half of the year. Against this backdrop, Australian equities should be able to push moderately higher (2-3%) by year end.
Be Active Against a Growth-Constrained Market
With local index performance likely constrained, we continue to advocate an active approach to Australian equities. While banks and the large-cap iron-ore focused miners appear growth constrained, there are promising growth prospects in some other areas
of the market. These include healthcare and IT, as well as a number of other globally oriented franchises. Mid and small-caps offer attractive prices for growth opportunities, even if higher-for-longer rates present some near-term headwinds for the small-cap end of the market.
Written by
David Cassidy, Head of Investment Strategy
David is one of Australia’s leading investment strategists.
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