The Australian equity market is on track for a strong financial year return (14%) and remains in positive territory for the current calendar year.
However, digging a little deeper into recent performance trends highlights some of the relative headwinds for the local market.
In contrast to global equities, the local market remains well off (5%) its early February highs. Indeed, Australia has underperformed global equities by a relatively wide margin this calendar year. Global equities have delivered 14% for the calendar year to date versus a more modest 3.9% (including dividends) for the local market.
Looking at the main drivers of Australia’s underperformance, we find 2 key factors.
Index Composition: from Favourable to Unfavourable
After being a virtue in 2022, our lack of technology exposure has been a relative disadvantage this year. The Australian tech sector has performed very well relative to the broader market this year but represents only 2.4% of total market index capitalization.
In contrast, the global technology sector accounts for 24% of the global MSCI index. In addition, the global consumer discretionary (Amazon, Tesla) and communication services sectors (Alphabet, Meta, Netflix) are also quite “tech heavy”, in contrast to the Australian comparatives.
Aside from our technology underweight, Australia’s significant overweight to banking and materials (mostly mining) are also weighing on index performance this year.
The mining sector has struggled somewhat against concerns over slowing global growth and the pace of the China recovery. Even more significantly, the banking sector has been weighed down by both global banking strains and local margin pressures.
The mining sector reacted positively last week to hopes for a more concerted China stimulus after last week’s modest interest rate cuts. There is still considerable debate as to how commodity intensive any additional China stimulus will actually be. Our medium-term view is that the key iron ore price will trend lower due to a structural slowdown in China, with demand decreasing and supply rising. However, near term stimulus announcements could once again buoy sentiment in coming months, as has been the case in the past.
For the heavyweight Australian banking sector, a positive catalyst is more difficult to envisage in the near term. We would expect rate cuts to buoy sentiment towards both the economy (lower bad debt risk) and loan demand.
However, the market is now expecting two more rate hikes and has pushed the first cut to early 2025. The market’s interest rate expectations can, of course, shift relatively rapidly, but the prospect of monetary easing currently appears a long way off.
RBA’s Belatedly Hawkish Pivot Is Making the Equity Market Nervous
From this perspective, we feel a growing concern over the Reserve Bank of Australia’s (RBA) belated policy hawkishness and, by association, the rising risk of recession, which was very low at the start of the year but is increasingly dragging on the Australian market.
The cash rate has moved from 3.1% to 4.1% this year, while the expectation for the peak cash rate has pushed up to around 4.6%. This has dragged not just on the banks, but also on most domestic cyclicals.
Near-term inflation outcomes will be an important determinant of what the RBA does from here. The recent monthly inflation print, alongside upside surprise on minimum /award wages, has pushed up rate expectations. The more comprehensive quarterly inflation survey for June, released in late July, will be a key signpost for the RBA.
For now the economy remains relatively resilient, with the labor market in particular remaining very tight. At the same time, sections of the economy are beginning to show signs of fraying, with housing construction very weak and retail spending clearly softening.
The Australian economy still has a degree of underlying resilience, as evidenced by ongoing labor market strength, so a local recession is not our central case, but risks of a policy misstep are rising.
The earnings cycle is also clearly weakening across a number of fronts. The largest downgrades of late have been from lower commodity prices and cost pressures. Demand related downgrades have been less prevalent but are starting to creep into the equation, with downtrends more likely to emerge in coming months.
We note Australia’s earnings momentum has recently been inferior to global equities, even though we still see Australian recession risk as lower than both the US and Europe.
Dealing with a Sluggish Local Index
In summary, Australia’s sector mix and our belatedly hawkish central bank pose challenges for performance of Australian shares, at least in the near term. On the positive side of the ledger, China stimulus could buoy the mining sector in coming months, though the medium-term trajectory for the iron ore price is still likely to be down in our view. The heavyweight banking sector looks to be running into stiff headwinds, with relief on the interest rate front seemingly a long way off.
We still expect the local market to push moderately higher this year (~3-5%), led by further gains in global equities. The recent improved performance from the Australian dollar should extend, which will drag on the performance of global shares from a local investor perspective.
Overall, we see three key takeaways for investors: (1) be active in Australian shares to outperform an index that has a less than ideal sector mix; (2) be adequately diversified into global equities; and (3) consider some partial hedging for global equity portfolios as the AU$ regains some lost ground.
Written by
David Cassidy, Head of Investment Strategy
David is one of Australia’s leading investment strategists.
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