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.
The equity market initially chose to look through the big bond sell off, but the longer bond yields remained elevated, the harder they were to ignore. With no meaningful economic downturn on the horizon, ‘higher for longer’ was increasingly expected to continue into 2024 and equity market valuations started to price in the higher discount rates. A softer-than-expected US inflation figure in November combined with a change in tone from the Fed resulted in a quick reversal of that view. The market, as is often the case, ran ahead and started pricing in a significant number of US interest rate cuts in 2024.
Expectations for cuts are not as imminent here in Australia, as our inflation seems to be stuck at elevated levels, but the prospect of meaningful relief at some point in 2024 has nevertheless also been seeping into our market’s consciousness. Although we can debate the reasons for, and sustainability of, higher (or lower) 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. Equity market earnings multiples are now above long-term averages, and when you compare the earnings yield of the equity market to the ten-year bond, our market looks expensive.
The Australian equity market is currently choosing to look over the valley of softer company earnings, focusing on this expected monetary easing instead and rotating towards cyclical exposures. We are however not convinced that when lower earnings are announced, they will be ignored by the market. We do therefore caution against blindly following the ‘soft landing’ narrative and embracing this cyclical rotation without considering earnings. Alphinity’s focus on earnings surprise remains a critical anchor to stock selection, as it is the only driver that will eventuate in sustained share price outperformance over time. Stocks surprising positively can be found in any type of markets and any type of company.
Looking ahead it’s not all doom and gloom! Although Australian earnings revisions have been suffering more than offshore recently, there have been upgrades in some sectors, like industrials 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.
Our portfolios were 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, Viva Energy and Xero. 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 noisy market of 2023 transforms from a cacophony to a symphony.
Author: Elfreda Jonker, Client Portfolio Manager & Investment Specialist
