During 2023 we faced an investing conundrum: ‘good news’ (i.e. strong economic data) meant ‘bad news’ for equity markets (as cash rates would need to stay high). Central bankers acted as the conductors of market reactions month to month, with every data release, good or bad, influencing the swings of their economic batons. Carefully trying to engineer a soft landing as they lifted interest rates, balancing slower growth, lower inflation, and geopolitical risks with a resilient consumer and tight labour market.
While the equity market has often chosen to look through the big bond sell off this year, the longer bond yields remain elevated, the harder they were to ignore. With no meaningful economic downturn on the horizon, ‘higher for longer’ is now increasingly expected to continue into 2024 and the equity market is starting to price that in. This presents headwinds to future overall market levels as higher discount rates may lead to lower valuations.
Although we can debate the reasons for, and sustainability of, high bond yields, the reality is that in the absence of any improvement in the earnings outlook for the market, there has been a growing disconnect between bond yields and equity market valuations. While equity market earnings multiples are largely in line with long term averages, when you compare the earnings yield of the equity market to the ten year bond, our market looks a little expensive. For a greater focus on earnings to be the key equity market driver, we might need some sideways movement in yields. And for the equity market to move sustainably higher, the overall earnings outlook also needs to improve.
But it has not been all doom and gloom! Although Australian earnings revisions have been suffering more than offshore recently, there have been upgrades in some sectors, like energy and mining. The Australian consumer is also holding up better than expected, with upgrades coming through for companies achieving ‘less worse’ outcomes, and with enough pricing power to offset cost pressures, for now. Revisions might not be positive yet but, thus far, there is no ‘earnings cliff’, and this has given the market hope.
At Alphinity, we have found that focusing on individual company earnings drivers and outcomes is key to generate performance over time. Our portfolios have been defensively biased throughout 2023, as earnings leadership has tended to be concentrated in companies with resilient earnings and strong pricing power, companies like QBE Insurance, CAR Group, James Hardie, Brambles, Cochlear, Medibank Private, and AGL Energy. We have continued to add selectively to both cyclical and growth exposures, where we see scope for earnings upgrades of individual companies, such as Rio Tinto and Viva Energy. Our aim is to have a well-diversified portfolio of idiosyncratic, quality earnings leaders.
Despite our Reserve Bank still appearing a few steps behind its global peers, we look forward to a period in 2024 when ‘good news’ will once again be ‘good news’, and the current noisy market of 2023 transforms from a cacophony to a symphony.
