As primarily bottom-up investors, we can often get an edge by talking to a company’s customers, suppliers, and management teams to assess quality – which is not always done well in the market. And this bottom-up work often leads to the formation of strong top-down views. For example, in 2021 we were confident that inflation was strengthening and would come in above market expectations and lead to higher interest rates. Now, our view is that inflation has peaked, but will remain elevated for some time.
Along with inflation and its impact on consumer spending, there’s a lot of global macroeconomic volatility impacting the market.
An update on consumer spending
Let’s start with a quick recap of the most recent reporting season.
This brought about a wave of volatility in the stock market, with one in every eight stocks experiencing movements of over 10% in response to their results, which is twice the usual average. This period was characterised by price-to-earnings (PE) expansion, explaining much of the market's upward movement. Investors seemed willing to look through some of the soft results by cyclical companies and buy them regardless, leading to PE re-rating. But they also sold defensives that had earnings misses – which could be seen in the earnings revisions. The average earnings upgrade was only 2.7%, and the average downgrade was around 9%.
The reporting season proved to be a tough one for consumer stocks, marked as the worst in 13 years. More than half of consumer companies downgraded their earnings by over 10%. Several factors played a role in this underperformance, as we had expected.
A significant part of the impact can be attributed to the peak effect of the transition from fixed to variable mortgage rates. Additionally, the phase-out of low and middle-income tax offsets, which provided households with tax refunds, created headwinds. As households steadily deplete their savings buffers, the effects rippled through to earnings. The struggle was evident not just in the earnings reports, but also in high-frequency retail spending data from Kepler, which showed a drop as steep as 12% year-on-year and real per capita consumption plummeting by as much as -5%; an unprecedented decline.
In terms of categories, electricals were particularly weak, but there were some doing quite well, such as those that thrive in good weather conditions (e.g. Wesfarmers, thanks to Bunnings’ results).
Inflation is staying high
While inflation may have peaked, it is expected to remain elevated for some time across the globe.
We are particularly concerned about the situation in the US, where fiscal spending continues at an unsustainable rate, and is contributing to higher bond yields. While those yields are rising, it is not solely due to inflation. There’s a shortage of demand for bonds, which propels interest rates upward.
The current conflict in the Middle East, while socially devastating, also has strong financial impacts. Tensions lead to higher oil prices globally, further increasing cost of living. We were already positive on oil because we thought supply would be under pressure, but again, that just gives us confidence with a higher oil price that inflation will remain elevated.
So, what does this mean for Australia?
We believe wages growth will remain strong here, because of our relatively rigid wage setting mechanism. We also believe energy prices are expected to remain high, so we’re in a similar situation where inflation, while it may have peaked out, should remain quite high. And as we saw recently, the RBA implemented another rate hike.
At the household level, the pressure is at its peak, with the transition from fixed to variable mortgages and the depletion of savings buffers taking its toll. Approximately 60% of households have already exhausted their savings, a figure expected to rise to 80% by the year's end.
Overall, as we expected, we saw a per capita recession but not an outright recession, and we can hopefully look forward to better conditions as we move through 2024.
A bit on banks
For a while, we've held the view that the banks’ margins were too high and would come down. The recent reporting season appeared to confirm this view, with pre-provision operating profits broadly disappointing as bank margins were squeezed. Offsetting this, credit costs continued to surprise positively, resulting in earnings that mostly met expectations.
We still see a lot of competition in the sector and rising costs impacting in the year ahead. We also forecast an increase in bad debts, as losses begin to normalise from its current very low levels. This will likely result in lower earnings for the sector over the next 12 months.
We have owned NAB, and we think that's the pick of the bunch – relatively less exposed to some of the concerns we have and looks more reasonable. But if anything, across our portfolio, we make a lot of being index unaware, and this is a great time where we think there's more opportunity out of sight of the major sectors of banks and resources, into some of the other areas where we see more quality on offer at better value.
The end is near (for the economic cycle)
Despite the challenges, there are still opportunities in the market for investors who choose wisely. And while it’s felt like a long, volatile cycle, we are nearer to the end than the beginning.
For some time, we’ve been talking about our expectations for earnings downgrades. In mid-late 2022, the market had 12 months forward EPS growth of around plus 8%. That's fallen by 14%. Expectations are now for EPS to decline in 2024 by around -6%.
Notably, the downgrades have been largely due to resources. Industrials have actually been surprisingly resilient, so we still think there’ll be further modest weakness in earnings, perhaps low to mid-single digit downside. But what will be different is that the downgrades are likely to come from the industrials.
How we’re positioning the portfolio
Our approach is to own the higher quality cyclicals – preferably those that have used the period of weakness over the past couple of years to improve their businesses, in anticipation of rates peaking and the next cycle commencing. For example, we invested in James Hardie this year, which has been a good call. While we knew the company could be impacted by higher US interest rates, those rates now mean less building. So, if anything, there’s more of an undersupply of housing in the US as we move through the next cycle – a little bit of pain now, but potentially more upside later.
Another sector we are overweight in is energy, with companies like Ampol showing strong performance due to our positive outlook on oil.
There’s been a lot of talk recently about the impact of GLP-1 drugs like Ozempic on healthcare stocks. It's meant that some of the healthcare stocks, which are in the bucket of defensives and are high quality companies, are now particularly cheap. We think in some instances they've been dealt with too harshly. In the longer term, we don't think health care stocks will be impacted by GLP-1 drugs, and therefore, oddly enough, it's actually the defensives that are quite often looking attractive now.
CSL, for example, is the top ranked stock in our universe on our quality value matrix. Even if we take the extreme view as to the uptake and adherence to all correct protocols by people that take GLP-1 drugs, CSL may see some competition in parts of its portfolio, but there’ll be minimal impact. At a recent investor day, CSL’s management forecasted double-digit earnings growth, with increasing return on capital. So, there’s still positive feedback from the industry.
Overall, the market looks relatively reasonably valued, perhaps even marginally overvalued. So, when you put all that together, given we know the market will look through the last part of the earnings downgrades, we're now starting to think about what we want to own for the next cycle.