Holding an overweight exposure to the Australian market leads to an unintended skew towards the financial and mining sectors, which together comprise 53.4 per cent of a highly concentrated market as shown in Table 1 below. An allocation to international markets broadens a portfolio’s exposure to global leading companies in the IT and Healthcare sectors, which are underrepresented in Australia.
This is a sound long-term strategic approach.
However, at this juncture and after a decade of low interest rates across developed economies, we are now starting to see indications of a turn in the market cycle. Higher inflation and normalising interest rates are expected to remain a feature for the short to medium term. For several reasons outlined below, these factors are aligning to make Australian shares a compelling tactical investment opportunity on a relative basis in the medium term.
1. Relative valuation
Despite the 8.2 per cent fall in the S&P 500 since the beginning of 2022 and after a decade of outperformance relative to global equities more broadly, US equities are still trading at P/E multiples close to their historical averages. The S&P 500 for example, has a forward P/E of 18.5 times, down from 22x at the start of the year and now in line with its long-term average of 18.6x. The derating is most apparent in the tech sector with mega caps such as Amazon, Alphabet, and other FANG+ stocks which were responsible for much of the index return over the past decade.
As the US market surged over this period, the Australian market lagged on a relative basis. Based on a Global Fund Management survey (Chart 1 below) it appears that global fund managers are repositioning away from US equities with a preference for more attractively priced investment opportunities
2. Longer path to higher rates
Annual inflation rate in the US accelerated to 7.9 per cent in February of 2022, the highest in 40 years. Energy remained the biggest contributor (25.6 per cent versus 27 per cent in January), with gasoline prices surging 38 per cent (40 per cent in January). Other countries including the UK and Eurozone are not far behind. As a result, in many jurisdictions, bond markets have priced in a path of interest rate hikes particularly over the short term to temper the spike in the cost of goods and services. Higher interest rates will push up borrowing costs for businesses and households and slow economic growth.
According to the Reserve Bank of Australia (RBA), a divergent path in Australia looks likely with inflation barely within their 2 to 3 per cent target band and wage inflation modest. Australia is also less impacted - but not immune - to rising energy costs as we are a net exporter of gas. China, our largest trading partner, is also seeing lower price growth with annual CPI at 1.5 per cent. Also, in contrast to other markets, China is taking a stimulatory approach to their economy adding liquidity rather than withdrawing Quantitative Easing. This should be a net positive for commodity producers.
3. Sector composition
The dominance of banks and mining stocks in the Australian market could present opportunities for stock pickers at this point in the cycle. Concerns over rising interest rates over the medium term could increase banks' net interest margins as the gap between lending rates and deposit rates widens allowing greater scope to increase margins. Rising rates also reflects a stronger economic environment which leads to greater demand for credit and lower bad debts. Insurance companies also benefit as they can invest in bonds with higher yields. Australian Banks are well capitalised and are expected to maintain their dividend payout ratios, which are high relative to other companies in the market.
As a major commodity producer, Australia is a beneficiary of rising gas prices, higher demand from reopening economies as well as higher agricultural prices. Commodities often have a positive correlation to inflation and play a safe haven role in inflationary environments and a hedge against falls in equity markets. Compounding the problem is the conflict in Ukraine which is impacting the supply of energy and other metals. A rise in demand combined with a reduction in supply could lead to a commodities super cycle.
4. Dividends and franking
Australia’s imputation system lends itself to higher payout ratios than global peers. Companies are incentivised to return capital to shareholders when there isn’t a compelling opportunity to reinvest earnings. This reduces the risk of management teams pursuing capital-intensive projects that may not be in the best interest of shareholders. The average dividend yield for the ASX 200 is 4 per cent which is significantly higher than the 1.3 per cent average of the S&P 500. If stock market gains are more muted in 2022, with lower capital returns than we have experienced over the past decade, a higher franked dividend could prove attractive given the lower risk profile than growth focused stocks.
Summary
The big winners of the past decade have been long duration global growth stocks. Much of their returns have been driven by higher earnings expectations, due to the pull forward in demand caused by the COVID pandemic. Contrast this to banks or commodity-related companies where long-term growth rates are not be expected to be materially different to the current rate. In a climate of higher interest rate expectations, it is these higher growth stocks who are expected to suffer on a relative basis as the earnings outlook for other sectors improves.
Despite the expectation of monetary policy tightening in Australia, inflation is relatively controlled thus far and short-term interest rates are generally favourable due to a slower than expected interest rate hiking cycle relative to other global markets.
Sinéad Rafferty, CFA – investment specialist, Fidante Partners
