Sydney Wealth Management | The information in this article is current as at 1 October 2022.
The S&P/ASX 200 Total Return Index returned 0.4% over the three months and -7.7% over the year to 30 September 2022.
S&P/ASX 200 Accumulation Index cumulative return (Sep-21 to Sep-22)
Source: S&P, Bloomberg
Recommendation: Move from neutral to underweight.
Australian equities are facing a period of significant uncertainty and challenges. While valuations are not necessarily unattractive, we believe there is meaningful scope for consensus downgrades in the months ahead. Current valuations look “cheap” but in reality, this is more akin to a “calm before the storm” moment with downgrades still to come in our view.
The macro backdrop has worsened materially, especially globally. A weaker global economy and slowdown in China bodes poorly for resource demand and other cyclical sectors such as industrial businesses. Higher interest rates support bank revenues by raising margins on their loan books, but this can often be more than offset by higher bad debts and weaker credit growth. Consumer sentiment has also fallen sharply, which bodes poorly for the retail sector.
In conclusion, risks have risen markedly. The RBA and international commitment to rate hikes raise the prospect of a global recession with equities tending to fare poorly in that environment. Accordingly, we maintain our underweight recommendation on the Australian sharemarket.
Our outlook for some of the major sectors of the S&P/ASX 200 is as follows:
Recommendation: Downgrade to underweight.
Our outlook for the banking sector rests on four key areas:
- How are net interest margins (the return earned on bank assets less the cost of funding these) trending?
- What are the overall prospects for credit growth?
- Our view on bank underwriting quality i.e. are they going to be writing off loans as bad debts?
- The trend in bank operating efficiency.
On the positive side of the ledger, bad debts are at extremely low levels with the RBA itself constantly reiterating the strength of household balance sheets in aggregate. The picture for bank operating efficiency is somewhat more mixed with Commonwealth Bank one of the sector standouts whilst others are embarking on sizeable capital spending programs or acquisitions to “catch up” to rivals. Net interest margins are also trending higher in the wake of the RBA interest rate hikes with banks arguably benefitting more than non-banks thanks to their greater reliance on retail deposits as a source of funding with the rising gap between these and loans the banks are writing accruing to the banks’ bottom line.
On the downside however, the economic backdrop is weakening. This would suggest the current period of strong net interest margins and low provisioning for bad debts appears unlikely to last in the year ahead. The rising cost of debt in the form of higher mortgage rates is having a material impact on the housing market and credit growth. While the other factors we consider are important, credit growth is one area that can dominate the outlook for bank returns. This is because a period of weaker expansion in credit means lower revenue growth with lower earnings and dividends for shareholders. We can see this illustrated below in the strong relationship between bank total returns (price growth and dividends) as compared to credit growth. We believe the downside risks are currently outweighing potential upside factors and we move to an underweight position on the banking sector.
Annual total return of major banks versus credit growth excluding refinancing (Sep-07 to Sep-22)
Recommendation: Downgrade to underweight.
Commodity prices have corrected sharply from peak levels in March. The below chart highlights the trajectory of base metal prices (iron ore, aluminium etc), now down 16% for the year to September. It also shows the rate of change in the OECD Composite Leading Indicator, a measure of the likely direction of economic growth for developed economies such as the US. This series tends to have a slight lead on commodity prices and its current trend is decidedly negative. We believe this will not change in the near term given rate hikes in the US and elsewhere are dragging on global economic growth.
Annual price growth of base metals versus OECD Leading indicator change (Sep-02 to Sep-22)
While in China, we have seen new stimulus packages brought forward. These are dwarfed by the demand destruction due to rate hikes in the US and elsewhere as well as soaring energy prices in Europe. We can see this depicted below in forecasts of global industrial production with 2022-23 expected to be difficult spells for both the US and Eurozone, a decidedly negative prospect for resource demand. The bounce back anticipated for China and Japan is an inadequate offset in our view.
Industrial production – actual and forecast for major countries (2021 to 2024)
Accordingly, we switch our positioning on the resource sector to underweight. While there are some segments of the market seeing a sizeable secular trend supporting demand e.g. lithium and other metals tied to electric vehicle production, our overall view suggests caution is warranted.
Recommendation: Downgrade to underweight.
In the latest reporting period, consumer discretionary stocks saw strong performance relative to market consensus with more companies reporting earnings above consensus forecasts relative to the number missing consensus views.
We are seeing a shift in spending away from goods towards services with real consumption in services rising 6.9% for the year to June 2022, over twice the growth of spending on goods (3.3%) for the same period. Consumer sentiment has fallen precipitously in recent months with the decline accelerating since the RBA rate hikes began in May. The index is now nearing lows last seen during the depths of the first coronavirus lockdowns in 2020. This result has been consistent with a marked decline in household spending historically.
Annual growth in Australian household spending against Consumer Sentiment (Sep-02 to Sep-22)
That does not yet appear to be the case with a timelier indicator, the Commbank Household Spending Intentions Index, pointing towards strong consumer spending continuing into September. While we accept these current coincident indicators, we believe the outlook has worsened markedly. The feedback from RBA rate hikes is only being felt on a delay given the much higher percentage of households on fixed rates relative to the pre-pandemic position. Household balance sheets were also in a stronger position thanks to government stimulus spending since 2020 to support the broader economy.
While these are powerful offsetting factors, we are beginning to see signs that they are breaking down. First, household savings are almost back towards the pre-pandemic average. This coupled with the parlous wage growth (negative after inflation) suggests households are only maintaining this spending by reducing savings, which cannot be sustained indefinitely. Second the fixed rate “shield” will be progressively eroded over the next two years with many households facing a material mortgage rate hike given the uplift in rates relative to the lows offered during the years following the pandemic. This will also act as a drain on household spending.
Overall, we believe meaningful drags on consumer spending are beginning to emerge. This will bode poorly for the retail sector after recent years of above-average profits (boosted by government stimulus programs) with a return to pre-pandemic profitability likely to be accompanied by further share price weakness.
Australian Real Estate Investment Trusts (AREITs)
Recommendation: Downgrade to neutral.
The AREIT universe continued to soften in the September quarter, underperforming the broader market index. Part of this is driven by the rise in interest rates and bond yields following RBA rate hikes. AREITs are often treated as bond substitutes due to their high distribution yields. As such, when bond yields rise, we typically see weakness in AREIT prices as they are now a less attractive alternative and see investors retreat from them. In addition, higher rates mean higher financing costs for property trusts which has the effect of lowering earnings and distributions to investors.
On balance, the price weakness has made AREIT valuations appear more attractive in terms of share prices relative to the assessed net tangible asset (NTA) value (a measure of the value of the underlying properties net of debt and intangible assets). However, this view assumes that underlying valuations are reasonable. We think that there is room for doubt with yields still trading at post-financial crisis lows for some sectors, particularly industrial property.
Property yields by sector (Aug-12 to Aug-22)
The above yields do not account for the lift in bond yields since the pandemic began with the 10-year bond yield up over 3% since February 2020. At some point these higher borrowing costs will be felt in property valuations, posing a risk to investor returns.
Most AREITs do however offer a measure of inflation protection not easily found elsewhere via the value of the properties themselves. In a higher inflation environment, it costs more to replace these assets, supporting the value of existing properties. Many AREITs also have a measure of inflation protection due to rents automatically escalating with inflation as part of lease agreements.
We remain concerned at the degree of potential risk of cap rate expansion for the sector. However, we cannot ignore the share price weakness seen year-to-date which has already, in our view, priced-in a bleak scenario for the property sector. The valuation case and the potential for inflation protection sees us maintain a neutral position, down from our June view of overweight.
AREIT sub-sector outlook
The office sub-sector recovery since the pandemic has continued to be a gradual one. Many workers have retained a more flexible workplace arrangement. This has seen businesses move to shrink their floorspace with even industry heavyweight Dexus doing the same as noted in their… presentation. Vacancy rates are also elevated in both Sydney and Melbourne. There are signs of gradual stabilisation with new supply to the sector slowing materially but this is a medium-term support in our view. It must also be measured against the cyclical nature of the sector which tends to underperform in weaker economic periods as office demand tends to shrink.
The residential sub-sector is seeing material signs of weakness with house prices correcting appreciably since the RBA began to hike. Developers such as Stockland have seen a sizeable decline in enquiries for their planned communities which halved across Australia from 36.7 thousand in the March quarter to 18.4 thousand in the June quarter. Higher borrowing costs with the rise in rates far outpacing wage growth are expected to continue weighing on the sector. The gradual recovery in immigration flows should act as a support over the medium term, but we would expect the current trend to persist until prices have sufficiently corrected.
The industrial sub-sector continues to benefit from solid investor demand, notwithstanding increased construction costs and maintenance expenses. Category leader Goodman Group has highlighted the ongoing demand with guidance of 11% growth in operating EPS for FY23. While the underlying demand dynamics are positive, we remain concerned at the tightness of current valuations and believe that there is potential for a material correction considering the current rate environment coupled with a slowing economy, both factors that should see demand fall and subsequently property valuations.