Mr Sargeant said that while higher interest rates have had a very limited effect on the behaviour of Australian consumers to date, the next stage of the market adjustment will see rates start to have an impact on their spending.
“We expect the current resilience in consumer spending to last through Christmas and into early 2023, and our conversations with company management teams suggest strong price rises will continue during this period.
“While inflation should then start to ease in the second quarter of next year, it will remain at elevated levels. This should see stronger-than-expected wage growth in 2023. It is no surprise that with many workers already seeing real wage cuts, the current level of industrial action is near 20- year highs.
“Combined with high energy prices and prolonged impacts to supply chains, many companies will enter the second half of 2023 with elevated cost structures.
“The danger is that households will then start reducing spending in response to higher rates – particularly those with mortgages that will reset from fixed to variable rates. Corporates may then have a combination of lower sales (with negative operating leverage), higher cost bases and higher levels of promotional activity. This would drive a squeeze on margins and trigger earnings downgrades in the second half of the year.”
Mr Sargeant said one of the unknown factors in 2023 is how this pressure on company earnings may flow back into labour markets as corporates reduce costs.
“We think one of the key factors in the resilience of consumer spending – despite the growing pressure on households – has been the rock solid labour markets. The risk is that this changes in the second half of 2023.
“Overall, there is clearly a higher level of economic uncertainty than usual, and risks are skewed to the downside. Despite this, a number of companies are well-positioned to thrive despite the uncertain times. We have seen companies such as Wesfarmers able to invest capital at attractive returns despite the tougher economic conditions. As the cycle progresses M&A activity is likely to pick up, creating opportunities for investors.
“Another area of opportunity is commodities. At Touchstone, while we have been long energy since the COVID lows, we have had limited exposure to the miners. This is due to our view that China’s property downturn was worse than widely appreciated, and stimulus programs and reopening would prove problematic due to low vaccination rates amongst the elderly Chinese population. We expected these headwinds to be compounded by slowing global growth and improving supply in some commodities.
“This thesis has played out, but many resource stock valuations remain elevated relative to the price of the underlying commodities they produce. Our general expectation is that commodities should strengthen post Chinese New Year, but broad macro weakness and a strong USD through 2023 may continue to be a challenge.
“Overall, 2022 has essentially seen the first stage of the market adjusting to a more normal level of interest rates after a decade of low inflation and artificially low rates. We expect that 2023 will see stage two of the market adjustment, with consumers cutting back on spending and corporates seeing margins narrow. For investors, the aim will be to identify the quality companies that can take advantage of these conditions to continue to generate strong cashflows and growth, while avoiding those that are vulnerable to cost and industry pressures,” Mr Sargeant said.
The content contained in this article represents the opinions of the authors. The authors may hold either long or short positions in securities of various companies discussed in the article. This commentary in no way constitutes a solicitation of business or investment advice. It is intended solely as an avenue for the authors to express their personal views on investing and for the entertainment of the reader.