End of Quarter Review – September 2022

The first quarter of fiscal 2023 has proved to be another exceptionally challenging period for global equity markets. The quarter was dominated by volatility brought about by central banks’ efforts to bring rising inflation under control. A spate of unified global interest rate increases from central banks, led by the U.S. Federal Reserve, has resulted in most of the major global economies slowing down to the brink of recession. The self-induced slowdown is causing investors to question whether such an aggressive strategy could overshoot the mark, possibly sending the global economies into a deeper recession than intended.

The Australian equity market also had to contend with the pressure from higher interest rates. The Reserve Bank of Australia (RBA) raised the cash rate by a further 50bps to 2.35% during its September 2022 meeting, and while the move was widely expected, the expectation of further hikes has acted as a headwind for share prices throughout the quarter.

Elsewhere, the Russia-Ukraine war continues unabated, causing global supply-chain disruptions, especially in Europe where energy and food prices have soared. There was some more good news on the global coronavirus pandemic, with COVID-19 case numbers continuing to decline, in turn increasing services sector activity and aiding a return towards a more ‘normal’ post-pandemic life.

The MSCI All Country World Index fell 7.3% to 553 points for the quarter, the S&P 500 Index lost 5.3% to 3,586 points and China’s Shanghai Composite Index was down 11.0% to 3,024 points. Domestically, the Australian S&P/ASX 200 Index hardly changed, falling 1.4% to 6,474 points, albeit some sectors performed much better than others. Healthcare and Information technology performed the best— rising 2.6% and 2.5% respectively. By contrast, the Utilities and Real Estate sectors were the weakest— down 13.6% and 7.0% respectively, mainly feeling the effect from higher interest rates.

The Australian reporting season for fiscal 2022 showed aggregate earnings were broadly in-line with analyst expectations for the year. The Australian Banks, however, underperformed the S&P/ASX 200 Index through the reporting season, as investors were disappointed by both the reported results as well as the forward commentary.

The Australian Resource sector had a mixed performance through the reporting season with energy outperforming mining.  While oil price volatility has continued, high oil and gas prices (both international and domestic) have enabled strong oil sector cash flow. Balance sheets are strong and need to be given both Santos and Woodside Energy Group have robust capex programmes ahead.

Rising wages in Australia are pressuring the cost bases of many mining companies and we have also seen raw material input costs up materially. In aggregate, raised capex and higher operational expenses saw mining sector earnings forecasts reduced through the reporting season.

On the commodities front, gold has started the new fiscal year on a defensive tone, down 8% to US$1,661/ounce for the quarter, mainly due to the strength of the USD. Iron ore retreated 21% to US$96 tonne in part due to lower demand and COVID-related lockdowns in China. Brent oil fell 16% to US$85/barrel—impacted mainly by a surging USD and the increased risks of a global recession which would cut demand.

Despite risks to global growth from a probable US recession in 2023, a substantial slump in the Euro zone, stagflation risks in the UK, and rising uncertainty over China’s near-term growth prospects, we forecast Australia’s economic growth for 2022 to be 4.3%. The growth is largely driven by a stronger consumer, buttressed by rising household incomes thanks to a strong labour market. However, we feel a sharp economic slowdown is inevitable in 2023. We expect higher interest rates to gradually weaken consumer sentiment and ultimately take its toll on the Australian economy.

Australian retail sales have remained healthy over the past year, with few signs so far that inflation and higher interest rates have slowed the average Australian’s spending appetite. That said, the RBA is expected to further raise interest rates from the current cash rate of 2.35% to a forecast peak of 3.6% in early 2023. We then expect the knock-on effect of higher mortgage repayments to kick-in over 2023, and dampen consumer sentiment resulting in a material slowdown in retail activity.

In addition, rising energy and wage costs are likely to translate into an even higher inflation reading in Australia and we now expect headline inflation to peak at 7.4% by the end of calendar year 2022, while underlying inflation will likely peak at 5.6% also by year end 2022. Underlying inflation is expected to remain well above the RBA’s 2%- 3% target band throughout 2023, and given a longer inflation overshoot, we now expect interest rate cuts to be delayed until the March 2024 quarter.

All up, we now expect the world economy to expand by 2.9% in CY22 and then 2.1% in CY23. As regards the more resilient Australian economy, we forecast growth of 4.3% in CY22 and then a much lower 2.2% in CY23.

While the global share market environment remains uncertain, and investors face the increasing likelihood of further volatility, there are some positive signs beginning to emerge. For example, the labor market tightness should slowly ease, supply chains are normalising, commodity prices are continuing to soften, and consumer demand is moderating as interest rate hikes slow the economy. For these reasons, we believe there is a reasonable expectation that the trajectory of inflation should be to trend lower, though not in a straight line. In the coming months, we expect a tug-of-war to play out between services and goods inflation.

The key question shaping the global economic outlook and share market outcomes is centred around the trajectory of inflation versus economic growth over the next year or so. With central banks committed to reducing inflation by means of higher interest rates for the foreseeable future, global equity markets face a headwind that will only dissipate when there is clear evidence the inflation genie is well and truly back in the bottle.

Against this background, the Australian share market is currently valued on a forward consensus price earnings ratio of 13.6x, which is 12% below the long term average of 15.4x. The forward consensus dividend yield for the Australian share market is 4.4% (80% franked) —or 5.9% grossed-up. In our view, however, earnings forecasts are likely to face downward pressure in the coming months.

For the benefit of our clients, we would like to reiterate our ‘Champion Stocks’ which have a long term positive thematic over the coming years and, therefore, we are not particularly concerned about the current year’s investment arithmetic or the analyst’s twelve month buy-hold-sell rating. Our ‘Champion Stocks’ are: Amcor, Brambles, Challenger, CSL, Goodman Group, Lendlease Group, Netwealth Group, Sonic Healthcare, and Transurban Group.