Equity opportunities … if you know where to look

The Australian equities market has exhibited substantial volatility through 2022 thanks to uncertainty about a range of micro- and macroeconomic elements. Nonetheless, investor sentiment remains bullish.

But they are keeping an eagle eye on a range of factors that have the potential to drive the performance of shares for the remainder of 2022. 

As daily headlines across the business press indicate, inflation, interest rates and geopolitics are the three main economic drivers investors are watching.

BlackRock managing director, Charlie Lanchester, said the team is monitoring inflation across the economy.

“It's not as rampant here in Australia as it is in other parts of the world, particularly the US. But it is still early days, so it will be interesting to see just how persistent and endemic it becomes in the next six months.”

Consensus indicates local headline inflation will reach 6% in 2022 against underlying inflation of around 4.75%, before easing to around 3% by mid 2024. 

CEO of Redpoint Investment Management, Max Cappetta, agreed inflation will be the critical factor for markets over the next six months.

“Higher and less transitory inflation will require already-lagging central banks to tighten monetary conditions with the real risk of tipping the global economy into recession in 2023.

"If inflation has already peaked, there is a chance a recession could be avoided. In this event, interest rates and monetary stimuli will be normalised back to pre-COVID levels, while a loosening of current supply chain issues will support ongoing growth with modest inflation.”

Lanchester said the determining element when it comes to interest rates’ impact on markets will be how fast they rise here and across the world.

“The bond market has already priced in a reasonably aggressive step-up in rates. What’s key is the effect on consumer behaviour. The transmission effect of rising rates is much more immediate in this country, because many people have variable rate mortgages. So, their cashflows will change almost immediately as rates go up. We shall see what effect that has on the underlying economy.”

There are various views about the direction of the cash rate. CBA expects the cash rate to be at 1.35% by year’s end, peaking in February 2023 at 1.60% and then on hold over 2023. In contrast, NAB says the cash rate will reach 0.75% by the end of 2022 and reach 1.25% by mid-2023.

Lanchester observed the stockmarket is predicting consumer spending will weaken even though unemployment is at record lows. The unemployment rate reached a low of 3.9% in April 2022.

Geopolitical risk is the third issue weighing on investors’ minds.

“Markets are observing the events in Ukraine and whether there is an improvement or a deterioration in this situation. This has flow-on effects for inflationary pressures across soft commodities, as well as oil and gas,” he said.

China’s pursuit of a zero-COVID policy is another geopolitical hot button, said Lanchester. 

“This has prompted shutdowns of parts of one of the world’s largest economies, adding to inflationary pressures. Just how that develops over the next six months is critical for companies and economies.”

Sector perspective

Markets have displayed clear sectoral bias over the past six months. Investors have been long resources stocks, which tend do well in an inflationary environment, and short technology shares, particularly companies that don't yet make a profit.

This is because with interest rates rising, the discount rate has risen and the value of tech shares has fallen as a result. Analysts use the discount rate, which is the interest rate used in discounted cash flow analysis, to work out the value of a company’s future cash flows.

Lanchester cautioned, however, against taking an overly-simplistic, helicopter view of markets.

“That's a very top-down way of looking at the market, particularly with the falls and rises we've seen recently. It's much more interesting to be more stock-specific. We find value across a range of sectors. In particular, we think small and mid-cap industrial stocks across a number of sectors look really interesting.

“As often happens in times of dislocation, companies at the smaller end of the market can fall a lot harder than the large caps, because their liquidity is lower. It only takes one or two sellers to panic and those shares can move substantially lower. That's where we are finding value.”

For instance, certain mining service companies are attractive, except those with fixed price contracts. Additionally, selective technology names are of interest. These are companies that have been consigned as loss-making and aggressively sold off this year, but which are actually on track to be cas flow positive, are still exhibiting excellent levels of growth and display proven business models.

“Unlike the tech boom of 1999/2000, we think there are some interesting names in that part of the market,” said Lanchester.

Cappetta agreed companies with strong operating positions, which are profitable, growing and paying dividends, may be safe havens for investors.

“This points to sectors where consumer spending is expected to remain robust regardless of tighter economic conditions. These include utilities, telecommunications, banking, consumer staples and healthcare.”

Financial services should also benefit in this environment, said Tony Davison, managing director of and financial adviser with Pride Advice Sydney. He agrees market conditions favour resources stocks.

“Banks are showing signs of resilience and this is likely to continue in the near term. While a global slowdown due to rising interest rates is advancing, commodity prices should be beneficiaries of an inflationary environment.

“We think the sector, particularly the mining majors, are well positioned to take advantage of conditions in the near and medium term. In principle, banks, should be more profitable in a higher interest rate environment, as long as impairments remain low and the majors are operationally sound.”.

As for sectors on the decline, Ray David, portfolio manager for Schroder’s Australian Equity Long Short fund, noted the consumer discretionary sector is facing significant headwinds. This is due to a thriftier consumer, given the absence of the pandemic-induced, government stimulus that brought forward consumption for household items over the past few years.

“Discretionary retailers face challenges with supply chains and reduced access to inventory, which is impacting forward planning. Embedded CPI escalators in lease agreements and union pressure to lift award rates in line with CPI could see fixed costs rise at the fastest pace since the pandemic, putting further pressure on this sector,” he explained. 

Australia v global markets 

Generally, however, investors expect local equities will remain attractive in the medium term, unforeseen events notwithstanding.

“The dividend yield and value of our market relative to other assets is likely to be a significant driver of shares over the remainder of 2022. Compared to the income returns of other investments, Australian shares still look fairly attractive,” said Chris Brycki, founder and CEO of Stockspot.

Data backs this up. Despite rising interest rates, cash, term deposits and Australian government bonds still only deliver a return of between 0.5% and 2.5% a year. Residential property rental yields in major Australian cities aren’t much better at 2.7% a year, according to SQM Research.

Also, most global stockmarkets are only paying 1%-2% in dividend income. Comparatively, the Australian stockmarket has an attractive dividend yield of 4%, which reaches close to 5% with franking credits. 

“In fact, the extra dividend return received from investing in Australian indexed shares compared to the RBA interest rate hasn’t looked as good for 20 years,” Brycki said.

Furthermore, from a historic perspective, the Australian stockmarket looks normally priced at the moment, based on its earnings multiple.

“The market price-to-earnings multiple, known as the price-to-earnings ratio, measures the market index divided by market earnings. It’s a quick and easy way to see how much investors are prepared to pay for earnings.

“A higher P/E means people are willing to pay more for earnings. That could be because they’re confident in those earnings growing or simply because alternative investments like cash or term deposits don’t offer much of a return. The Australian market, measured by the S&P ASX/300 is currently near its long term historical average of 14.8 times earnings,” he noted.

Possible risks

Risks abound, however. For instance, Davison noted the rapid decline in the Australian dollar since the beginning of April may have further to play out. He also said it’s important to look beyond these shores when forming investment views.

“Global inflation significantly impacts the Australian market. When it comes to interest rates, where rates go in the US, Australia will go to some extent. So it’s important to see our market in a global context.”

The elephant in the room is ongoing COVID-19 disruption. As recent shutdowns in China due to COVID-19 outbreaks demonstrate, while it’s easy to assume the pandemic is over, this could be wishful thinking. The possibility of a particular virulent strain shuttering global markets once more is also well within the realm of possibility.

On balance, however, investor sentiment remains positive and there are numerous reasons, such as the strength of the local economy, to be bullish about Aussie equities. Time will tell how the market performs for the remainder of 2022.