Today we explore domestic equities.
Schroders portfolio managers Ben Chan and Adam Alexander
Reflecting on 2023, have the challenges outlined last year, such as labour shortages, higher energy prices, and inflation, continued to impact domestic equities, especially in light of the aggressive monetary tightening cycle pursued by central banks?
Reflecting on the past 12 months the impact was probably less severe than it could have been but all of those issues have certainly played a part in specific equity market sector performances during 2023, especially as the rebound in economic activity post-COVID is now firmly in the rear view mirror.
Inflation has proved to be a double-edged sword for many companies given it has created cost pressures, but for those with genuine pricing power it has actually facilitated revenue growth and in some cases margin expansion. In fact, inflation has actually proved to be a catalyst for some companies to realise the extent of pricing power their business does have. We have seen price rises across most categories of retail and industrial, everything from telco and accounting subscriptions to pallets and pyjamas. On aggregate business margins have been surprisingly resilient.
Consumers are still battling increasing costs on a number of fronts and spending patterns are certainly migrating from discretionary items to staples with a distinct pull back in spending on big ticket household items. As we move into FY24 we believe it will become difficult for businesses to continue to take price, especially as consumers run out of spending capacity. Earnings growth will likely become more difficult to come by with aggregate estimates forecasting a decline in the mid-single digits (versus a historic growth average of +5-6 per cent).
Considering the global economic issues and those of the geopolitical kind, how have these impacted the appeal of domestic equities for investors?
At a global thematic level, the pervasive impact of demographics and decarbonisation on global economies is indisputable. Energy transition and the path to decarbonisation depends heavily on investment in the raw material and mining sectors. Fortunately, Australia has many companies listed which create investment opportunities in this space which we remain positive on.
In addition to materials required for the clean energy transition, the increasingly unstable geopolitical environment is driving governments and companies to diversify supply chains for critical material inputs. Once again, Australia’s rich reserves in copper, nickel, aluminium and lithium to name a few, combined with a (reasonably) transparent and stable regulatory environment have excellent appeal to global manufacturers.
Most commodity prices, with the probable exception of iron ore, and until recently lithium, do not appear elevated versus industry cost curves. Couple this with the pathway for new mining projects becoming increasingly environmentally complex and expensive, then the combination should remain very supportive for current producers and the assets they already have in place.
Looking ahead to 2024, what are the key factors or events that investors should closely monitor, and are there any emerging trends or risks that may significantly shape the trajectory of domestic equities in the coming year?
Interest rates will likely continue to be a key area of debate, however we now expect the rhetoric to shift to the prospect of cuts, particularly if inflation abates. While timing is uncertain, over the coming year or two, our expectation is for a return to more historically ‘normal’ interest rate levels rather than the extremes lows seen since the global financial crisis (GFC) of 2007/8. We envisage this adjustment back to a level at which debt holders expect at least some compensation for lending money to consumers, businesses or government seems unlikely to occur quickly and painlessly.
There has only been a modest adjustment in equity valuations to date, resulting in equity prices still commanding premium valuations versus history, particularly outside financials and resources, suggesting investors remain complacent about a prolonged higher rate environment that which we have not seen in over a decade. With government and consumer debt, house prices and inequality closer to extremes than averages, a return to growth fuelled by cheap money is not our base case scenario.
To this end we remain cautious on the financial sector and those second derivatives. Australia was spared a deep credit cycle during the GFC and low interest rates in the 15 years since have investors' memories being tested as to financial impact from a credit cycle. Provisions for bad and doubtful debts remain low and we are yet to see any meaningful tick up in delinquencies as consumers paddle furiously to keep up with mortgage payments.
Are there additional sectors you see as potential winners or losers in 2024?
Despite an underwhelming year of returns in CY23, the starting point of equities prices for CY24 remains uncomfortably high. Starting valuations, or the price paid for an investment, remain vital to future investment returns, and that starting point remains above historic averages for a large segment of the market. With a decade of financial tailwinds now turning into headwinds, high multiple companies which have driven a large part of the markets performance in recent years are likely to come under pressure as investors acclimatise to a “higher for longer” rate environment.
We are tilting our portfolio exposure to the real economy through selective resource, energy and materials companies. Companies where we see value have reasonable and tangible strategies put in place by management teams to deliver earnings growth and acceptable returns from existing assets.
We also favour industrial companies with established products and (ideally) a proven track record of execution across a broad range of sectors including supermarkets, logistics and chemicals. Specifically, companies that have strong moats, a compelling value proposition for their customers and robust balance sheets. With the backdrop of a sideways grinding economy these companies should have a strong chance to prosper as consumers recalibrate to higher interest rates and sticky inflation.
