While the Australian equity market is down ~3% in price terms this year to date (positive 2% including dividends), the local market is well ahead of global equities, which are down ~11% (8% including dividends) in AU$ terms for the year so far.
At the aggregate level, we can attribute Australia’s relative resilience this year to our strong earnings performance, especially in terms of earnings per share (EPS) growth and positive earnings revisions, as well as a higher relative dividend yield. Interestingly, Australia’s market multiple has de-rated at a similar rate to global equities (down 20%).
Australia’s Inherent Sector Tilts Are Important
Closer inspection reveals that a lot of these aggregate trends have been driven by Australia’s unique sector mix. The largest contribution to Australia’s relative outperformance this year is our large comparative underweight in the information technology (IT) sector. This impact is closely followed by Australia’s overweight in the relatively well performing materials sector, while Australia’s overweight in financials has been a moderate contributor to our relative outperformance. The fact that Australia’s heavily weighted materials (mostly mining) and financials (mostly banks) sectors have also outperformed their global peers has also helped Australia’s relative performance beyond the raw sector weight.
While Australia’s absolute performance has been below average, Australia’s relative outperformance this year reverses a 5-year run of underperformance. The reversal in performance in the previously high-flying global IT sector is the key to this. This also manifests in relatively more resilient earnings performance (boosted by materials and financials in Australia’s case). The energy sector has of course been the standout performer in terms of price performance and earnings growth. However, Australia’s weight is relatively similar to the global benchmark. Energy has bolstered the overall index but has not influenced the relative performance of our market.
The 2023 Outlook from a Sector Perspective
The importance of inherent sector tilts and relative sector performance helps frame the outlook for the Australian market in 2023, not only in absolute terms but also when thinking about relative overweight and underweight positioning in Australia versus the rest of the world (we are overweight Australian versus global equities).
From a sector perspective, Australia stands a good chance of performing well in both absolute and relative terms if materials (mining) and banks do relatively well. Conversely, IT holds the key to the absolute and relative performance of the global equity market given its dominant weight.
Thinking about Market Valuation
Currently, Australia’s aggregate valuation appears relatively attractive on a simple PE basis (14.2x). However, once again, sector impacts need to be considered. Australia’s current low PE is in part due to booming earnings in the resource sector, which is flattering Australia’s PE ratio somewhat. More stable measures of valuation (e.g. price to book) suggest that Australia is still on the cheap side of fair value, although undervaluation appears more marginal.
Australia’s Economic Outlook and the Banks
Australia’s economic performance in 2023 does also impact our market view. Domestic economic performance is particularly important in respect of the bank sector outlook, though we feel investors need to dig deeper than just broad trends in GDP and employment.
Importantly, the consensus expectation that Australia will grow faster in 2023 than the major global economies of the US, Eurozone, UK and Japan will not guarantee outperformance. We expect Australia’s economy to slow in 2023, although it should continue to grow.
We see recession risk for Australia in 2023 as relatively low. While this is supportive for the market, we do see the housing sector and housing-related credit growth as the areas of the economy most vulnerable to rising rates and, by extension, to a significant step down in growth rates. As a result, we are moderately underweight in banks, not because of concerns around recession and spiking bad debts but due to our expectation of a lack of top-line growth. This is likely to present a relative headwind for Australian equities, though it does not in itself preclude the index from grinding out some decent gains.
Mining Remains a Swing Factor
The mining sector is arguably an even bigger swing factor given its inherent volatility. We have previously voiced concerns that the medium- to long-term outlook for our most important commodity, iron ore, is not looking as robust as it has historically.
The prospect of China re-opening in 2023 does offer a beacon of hope for the mining sector. We doubt there will be anything like the traditional impact on commodities from policy induced growth acceleration, though re-opening might provide some short-term support for iron ore and the mining sector. However, beyond a short-term sentiment boost, a structurally constrained Chinese housing sector suggests the medium- to long-term iron ore outlook is likely to be subdued. While we continue to see better supply-demand trends in energy and energy transition commodities, iron ore remains the more dominant influence on overall market performance. Subdued performance from the big iron ore miners is likely to cap medium-term upside.
The fortunes of the tech sector remain something of a global macro call. We think prospects of a performance pick up are reasonable on the basis that inflation eases and the Fed halts its hiking cycle, allowing bond yields to drift lower. Global equities offer better exposure to this scenario of a tech revival, though next month’s US inflation print will be important in laying a more positive foundation for tech and global shares into 2023.
As does the Australian Dollar
Finally, the path of the AU$ is an important consideration for weighing up Australian equities versus global shares.
In itself, the AU$ is unlikely to matter much to the absolute performance of our index. However, a decent lift in the AU$ could crimp the absolute return on global equities. We do not see huge upside in the AU$ as a central case, though a 5-10% appreciation of the AU$ bears consideration in thinking about the performance of global shares.
Our base case suggests some partial hedging as well as keeping a tactical tilt in favour of Australian equities. For now, we remain neutral in equities with a slight overweight to Australia balanced by a slight underweight in global equities.
The mid-December US inflation print is an important signpost for any incremental shift in absolute and relative equity weightings.
Written by
David Cassidy, Head of Investment Strategy
David is one of Australia’s leading investment strategists.
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