Australia and New Zealand Equity Market Outlook Q3 2022
Inflation is at its highest level at 5.1% to March, with real wages (pre-wage announcement) at just 2.4% meaning real wage growth is/was falling rapidly. The combination of high inflation and raising rates has cause a repricing in the equity market, but realistically a recession isn’t on the cards yet.
Unemployment remains at a 50-year low (though Underemployment is an issue) and GDP continues to grow, with the last reported Qtr up 3.4% (Dec 2021). It is important to remember that the definition of a recession is two consecutive qtrs. of negative GDP growth.
But has the market falls, we can see the Australian Equity market is the cheapest it has been since May 2020.
Australian Equity Market Weakness Offers an Opportunity to Be
‘Greedy When Others Are Fearful’
Equity market weakness continued into the second quarter of 2022, with the Morningstar Australia Index falling 14% and reversing the first-quarter rebound, as shown in Exhibit 1a. The average share price decline across Morningstar’s Australia and New Zealand coverage was 18%, to June 20, 2022, reflecting the relatively weak performance of smaller and higher-risk companies as investor concerns grew.
Market weakness is primarily driven by rising inflation and rising interest rates, and the worry rates are likely to further increase. Rising rates are creating cost of living pressures and concerns of a recession. The surge in the 10-year Australian government bond yield, to over 4% from its low of just 0.7% in October 2020, as shown in Exhibit 1b, is encouraging equity investors to increase equity yields. This is usually achieved in the short term by lowering equity prices. However, rising nominal bond yields implies rising inflation and rising nominal earnings in many cases, all else equal, which the market appears to be overlooking.
The Australian Economy Is Well-Positioned for the Likely Decline in Economic Demand
Inflationary pressures continue to grow in Australia, with annual consumer price inflation, or CPI, increasing by 5.1% in March 2022. This is
its highest level for 20 years, as shown in Exhibit 2a. The most recent federal government inflation forecasts, made in March 2022, now look
unrealistic. Actions by the recently elected federal government may also put further upward pressure on inflation. The Reserve Bank of Australia’s, or RBA’s, forecasts, made in May 2022, still look reasonable, though the governor of the RBA has since said inflation is likely to peak at around 7% by the end of 2022, or 1% above the RBA’s official forecast. Importantly, inflation is well above the RBA’s target of 2%-3%, which puts upward pressure on interest rates.
Rising inflation has caused the 10-year government bond yield to rise to 4.1% currently from its low of 0.7% in October 2020. The RBA’s 0.5%
increase in its cash rate target to 0.85% in June 2022 was larger than expected and shows the urgency to contain inflation. Cash rate futures
have also continued to rise, and now forecast a cash rate of over 4% by mid-2023, as shown in Exhibit 2b, implying variable mortgage rates of around 5%-6%, well above the sub-2% mortgage rates available in 2021.
CPI inflation is tracking well ahead of annual wage inflation, at 2.4% in March 2022, creating a growing cost-of-living squeeze. In addition, rising interest rates and mortgage servicing costs will pressure household budgets and consumption, increasing the risk of a recession in Australia. Morningstar’s Australian equity forecasts incorporate a normalisation of corporate earnings following pandemic-related distortions but we aren’t expecting a recession. We also continue to use a long-term midcycle nominal risk-free rate of 4.5% within our discounted financial models, which incorporates inflation of 2.25% and a real interest rate of 2.25% which is broadly in line with the RBA’s assessment of the “neutral interest rate” of around 2.5%.
Rising Interest Rates Take Gloss off Commodities; Miners No Longer Expensive
Commodity prices seemingly sailed through the early days of the market correction. With the focus on supply disruption and the war in Ukraine, sentiment toward the mined commodities remained relatively positive despite growing concerns around the broader global economy. However, more recently, the sector has not been immune to the challenges to China’s economic growth and broader market sentiment. It has fallen more than 15% from the record peak in early April 2022 (Exhibit 3a). With the index off its highs, we no longer see the miners as expensive. Based on the closing share prices on Friday June 17, we see our basic materials coverage as trading at about a 12% discount to our fair value estimates on average (Exhibit 3b). However, we caution the sector is not yet at bargain levels. Recent declines in near-term prices of iron ore, coal, and base metals mean there is a likely headwind to fair value estimates with our next updates. While iron ore has fallen of late, around USD 110 per tonne is still a healthy and very profitable level for the iron ore miners. Similarly, thermal coal and
coking coal both close to USD 400 per tonne, copper above USD 4 per pound, and zinc at USD 1.60 per pound are not signs of an industry in
pain (Exhibit 3c). Rather, we’d still see industry profitability above midcycle levels based on those prices, and with iron ore and coal, well
above. It appears the market is beginning to factor in further price declines beyond current levels, which we think is reasonable and likely.
In our mining coverage, Newcrest remains one of our cheapest where we see upside from development projects underway and likely improvements at Lihir. Gold can also exhibit some countercyclical attributes relative to other asset classes such as bonds or equities. South32 and Mineral Resources also trade in 4-star territory. While the iron ore miners have sold off, they remain the most overvalued of our basic materials coverage. In particular, we call out Fortescue given its elevated position on the cost curve and greater leverage should iron ore prices fall, as we expect longer-term. As of June 17, our building materials coverage screens approximately 30% undervalued. We still expect a strong 2022 underpinned by demand for residential housing in Australia, New Zealand, and the U.S. There is a deep backlog of demand. However, with interest rates rising, there is a risk that activity will cool into 2023. Explosives companies Orica and IncitecPivot have been quite resilient so far, and are close to fairly valued.
Telecoms a Safe Haven While Media Earnings Are Susceptible to Economic Uncertainty
We view earnings of telecommunications companies under our coverage as relatively resilient against the backdrop of rising interest rates and economic uncertainty. This is due to the essential nature of their services, underpinned by their ownership of infrastructure assets critical to the functioning of the economy. Moreover, three out of four of the telecom names (Spark, Telstra, and TPG Telecom) under our coverage have narrow economic moats.
The telecom sector is still poised to benefit from favourable tailwinds. First, the resumption of international travel will increase high-margin global roaming revenue. Second, increased penetration of 5G is likely to increase average revenue per user while further easing competitive pricing in the industry as players look to generate a satisfactory return on 5G infrastructure investment. Third, in broadband, we believe earnings declines, as customers transitioned to the National Broadband Network, are bottoming out. While absolute high debt levels expose the telecom sector to likely interest-rate increases, overall leverage metrics are comfortable, and we see little risk to dividends.
The outlook for the media sector is less positive. Revenue in this advertising-dependent space are highly leveraged to economic swings and earnings are vulnerable to inflationary pressures on content, talent, and employee costs. Continuation of a post-COVID-19 recovery in sector earnings could be derailed if there is an economic downturn and advertiser confidence slumps.
We expect the cyclical impact on earnings to be worse for media companies with greater exposure to traditional media (for example, free-to-air-television and print) given the continuing structural challenges from digital media and changing entertainment consumption habits. Digital advertising revenue streams are more resilient to economic downturns. Hence, we expect companies with higher proportions of earnings from digital and subscription-based businesses to fare better amidst the potential macroeconomic headwinds.
Semiconductor Shortages Weigh on New Vehicle Sales Volumes, but Support Elevated Profitability for Dealers
The consumer cyclical sector endured a brutal second-quarter 2022, with a negative return of 21% trailing the market’s 14% decline. The decline wiped out the gains consumer cyclical companies made over the broader market since the pandemic, with the sector up 26% since the first quarter of calendar 2020, versus the market’s 31% gain (Exhibit 5a). We now view the sector as undervalued with consumer cyclical companies trading at a discount to our fair value estimates on average (Exhibit 5b).
Semiconductor shortages continue to weigh heavily on new vehicle supplies, with calendar year-to-May car sales volumes 4% lower than
2021 (Exhibit 5c). This is weighing on revenue for dealers such as Eagers Automotive and accessories manufacturers such as ARB. While there is little respite for accessories suppliers, we expect dealer profitability to remain elevated as demand continues to outstrip supply—Eagers’ orders exceed deliveries by about 34% year-to-April. As inventory cannot be easily replaced, there is little incentive for auto retailers to discount.
We estimate much of the impact of tight supply to persist in the near term, but the chip shortage to eventually pass, and supply constraints to gradually ease. As supply chain issues ease, we expect pandemic-driven tailwinds for Eagers to moderate. Most notably, we expect the sharp reduction in discounting to revert, resulting in lower operating margins. We forecast margins further moderating in 2023 as supply replenishes and demand normalises. With increased vehicle supplies to the Australian market, we expect competition among car retailers to return, necessitating a normalisation in personnel expenses—namely in sales and marketing.
By contrast, demand for wear and tear vehicle parts remains solid. Demand for automotive spare parts (required for routine maintenance
and repair of vehicles) is linked to the overall size of the vehicle pool, rather than outright sales. We expect the number of registered vehicles in Australia will grow at low-single digits over the next decade, marginally outpacing population growth. There are currently more than 19 million passenger vehicles in Australia, with an average age of over 10 years, and more than 14 million older than five years—squarely in target market for narrow-moat Bapcor’s used parts retailing business (Exhibit 5d).
Consumers Sandwiched Between Rising Prices and Higher Rates of Discretionary Spending
On average, we view the sector as slightly overvalued (Exhibit 6b), with the average consumer defensive stock trading at a 3% discount to our fair value estimate. Nearly half of consumer staples names strike us as undervalued, trading in 4-star territory. The most attractive names are a2 Milk and G8 Education. Conversely, supermarket operators Woolworths and Coles, remain the most expensive stocks in the sector.
Consumer pressure is mounting as they face higher prices at the till and higher mortgage payments. Rising inflation has triggered the RBA to hike interest rates, with money markets pricing in more increases in the near term—futures are implying the cash rate will reach a cyclical peak of around 3.6% in 12 months. Equity markets have already responded with a sharp selloff in discretionary retailer shares, with the correction accelerating in late February 2022. Average prices of discretionary retailers in our coverage universe are down over 30% since July 2021. However, share prices of consumer staples retailers’ we cover have significantly outperformed in relative terms—average share prices are virtually flat from a year ago (Exhibit 6c).
Market’s perception of the relative defensiveness of food and liquor retailing compared with categories such as consumer electronics and sporting goods. We expect demand for goods sold at Woolworths, Coles, and Endeavour to remain robust and staples retailers to be net beneficiaries from rising shelf prices. Recent reports from large U.S. retailers Walmart and Target support this thesis. For more detail, please see our analyst note “Australian Discretionary Retailers Likely to Experience Similar Consumer Pullback to U.S. Peers” published May 19, 2022.
Nevertheless, consumer staples retailers screen as materially overvalued at current share prices. Continuing monetary tightening by the RBA could be a catalyst for their earnings multiples to re-rate. Supermarket P/E multiples are too high based on our low-single-digit EPS CAGRs over the next five years. We think the market is factoring in continued low discount rates, reflective of the low interest-rate environment we’re now emerging from. While also overvalued, Endeavour’s mid-single-digit EPS CAGR and wide moat rating warrant a greater P/E relative to the supermarkets. Its undisputable position as Australia’s largest liquor retailer gives it with the opportunity to drive profit margin expansion and increase earnings ahead of a more muted market growth.
Near-Term Earnings and Cash Flow Soaring on Gas Supply Disruptions
The energy markets continue to be dictated by events in Ukraine. Brent crude sits above USD 115 per barrel as we write, more than 400% ahead of USD 22 per barrel March 2020 lows and well ahead of the USD 71 per barrel 2021 average. Natural gas prices remain elevated as well, with the LNG Japan/Korea Marker at USD 34 per mmBtu or 15 times 2020 lows of USD 2.20 per mmBtu and nearly double the USD 17.80 per mmBtu 2021 average.
These are extremely healthy prices for oil and gas companies where earnings can generally be expected to more than double in calendar
2022. We can say that relatively confidently given we are already halfway through the calendar year, and contract LNG prices are struck with a one-quarter lag to the crude price. The major energy companies will be integrating their recent purchases this year, including Santos’ merger with Oil Search and Woodside’s merger with BHP Petroleum. But with the sharp spike in energy prices, we also expect them to focus on near-term maximisation of production where possible.
Given the comparatively sharper rise in gas prices relative to crude oil, companies with export natural gas exposure like Woodside and Santos stand to benefit most, particularly if they can eke out extra LNG production for delivery outside of contract and into premium spot prices. Price-bolstered cash flows open the potential for capital management, buybacks, and/or special dividends. And strengthened balance sheets and demand for product grease the wheels for new project development. But we still think the higher prices are likely to be transitory—our midcycle price forecasts remain USD 60/bbl for Brent crude and USD 8.50/mmBtu for contract and spot LNG from the June quarter of 2024.
Market Focused on Downside Risks, but Banks and Insurers Should Benefit From Rate Rises. Asset Managers Still Cheap
With the RBA lifting rates more quickly, and potentially higher than we originally expected, loan impairments could weigh on bank earnings in 2023 and 2024. We think the market has overreacted to the earnings and valuation risk though. Even if losses exceed long-term averages, as well as our forecasts, it is unlikely to be persistent nor large enough to be material in the context of each bank’s future earnings profile and equity value. We expect a reduction in discretionary spend to help keep delinquencies down, and households with record equity buffers and savings should also help. The banks are well-provisioned and capitalised which provides comfort that equity raisings are not likely and dividends can be maintained. We expect a modest increase in dividends in 2022.
We continue to expect revenue upside for the banks, as greater cash rate increases are passed to existing loans more than for customer deposits. We forecast credit growth to slow in the second half of 2022, as higher interest rates and inflation reduce borrower capacity and weigh on investor sentiment.
Fiscal 2022 is likely to be another challenging year for general insurers, with IAG Group and Suncorp exceeding original provisions for large
hazard events and facing steep inflation on repair costs. Repricing and a focus on operating expenses will help, as will higher cash rates. The nomoat-rated insurers should begin to see investment income on policyholder and shareholder funds materially improve.
We see good earnings prospects for Challenger. Demand for its annuities is growing alongside rising bond yields, and it aims to selectively lend to borrowers at premium rates in the current risk-off environment. Credit Corp could see earnings growth from having more nonperforming loans for purchase (and collections), and from pursuing cost-saving initiatives like offshoring and digitising processes.
Asset managers are cheap but their near-term earnings outlook is mixed. Earnings prospects are better for younger, stronger performing asset managers: 1) with an expanding product suite like Pinnacle; or 2) where the current track record is top-quartile like GQG Partners. Meanwhile, the mature players like Magellan and Platinum need to improve performance and stem redemptions. The earnings upside from these initiatives will likely only manifest over the long term.
Healthcare Begins to Look Attractive Again After Recent Selloff
The healthcare sector significantly outperformed the Morningstar Australia Index in the June quarter of 2022 (Exhibit 9a), but has not been
completely immune from market concerns. The only meaningful share price gain in the June quarter was Ramsay Healthcare which received a bid from a consortium of financial investors led by private equity firm, KKR.
With the recent selloff, we now view the sector as undervalued on average (Exhibit 9b). We see several buying opportunities in healthcare
with about half our healthcare coverage trading in 4- or 5-star territory. The most attractive names are: Ansell where we see margins expanding (Exhibit 9c); ResMed where we expect supply constraints to alleviate; Sigma, Fisher & Paykel, and Avita. Meanwhile, Pro Medicus,
Ebos, and Cochlear remain relatively expensive.
We generally view companies in our healthcare coverage as defensive and fairly insulated from rising inflation or a potential Australian recession due to the essential nature of the products and services. This broadly translates to pricing power and an ability to pass on rising input costs to customers without a material impact on demand. We also do not expect a material negative impact on profits from rising interest rates due to a lack of debt in the sector overall.
Our outlook for the sector is largely unchanged. While the path forward may be volatile, particularly if new coronavirus variants emerge, we still expect continued mean reversion for the temporary winners and losers of the pandemic. We expect the overall downward trend in coronavirus testing to continue, a headwind for pathology providers, Sonic and Healius. Elevated demand for Ansell’s single-use gloves and Fisher & Paykel’s hospital hardware is also likely to continue normalising.
Conversely, we expect fewer surgical restrictions to give relief to Cochlear and Ramsay Healthcare. Increasing social mobility is likely to benefit CSL’s plasma collections and ResMed’s sleep apnea diagnosis rates. While we think margins for the sector are still broadly under pressure due to higher freight and safety costs, staffing challenges, and supply chain disruptions, we think these pressures will mostly resolve longer-term as the pandemic subsides. We think future disruption from coronavirus will be limited, and hospitalisation rates should trend down given higher vaccination rates, newer treatments, and hospitals being much better equipped and experienced with treating COVID-19 patients.
Positive Outlook for Construction and Engineering Stocks; Toll Roads and Airports Continue to Recover
Toll road traffic volumes are back to pre-COVID-19 levels in most markets, and distributions to shareholders should return to peak levels shortly. The outlook for Transurban and Atlas Arteria is good. Tolls on most roads are linked to CPI and should benefit from the recent inflation surge, while extensive interest-rate hedging should protect from rising rates at least for the medium term. Traffic volumes, however, may weaken if we have a recession. Trucks, which typically pay tolls three times higher than cars in Australia, are sensitive to consumer spending and construction activity. Full recovery for airports remains a couple of years away, in our opinion.
For April, Auckland Airport reported that domestic and international travel was still down 39% and 75% on pre-COVID-19 levels.
Share prices for logistics companies have weakened recently as central bankers flip from loose monetary policy to rapid tightening. Sharply rising rates and other imposts on disposable income are likely to cool the housing boom, consumer spending, and construction activity. Most hard commodity prices are also now weakening as global demand slows. The medium-term outlook for logistics firms has deteriorated but at least balance sheets are healthy. Kudos to Qube Holdings, which appears to have perfectly timed the sale of its warehouses at the peak. Sale proceeds halved net debt/EBITDA to a conservative 2 times, slightly below peers Aurizon and Port of Tauranga.
We still think engineering and construction companies are likely to do well in 2022. An unwinding of the impact of COVID-19 and delayed
contracts being awarded is a theme for the sector, though skilled labour shortages are challenging in the near term. Defence spending is
underpinned by a strong government commitment for the next 10 years with Downer EDI and Ventia key beneficiaries. Seven Group also flagged positive momentum across its businesses, expecting an EBIT increase of 8%-10% on fiscal 2021, including growth from Coates Hire and WesTrac.
We think Brambles is managing inflationary pressures reasonably well. While inflation across labour, lumber, and transport is a headwind, we think Brambles can recoup these costs in the medium term through surcharges, inflation indexation, and price increases. We see strong
competitive advantages persisting for Brambles, hence the wide moat.
Substantial Correction Creates Opportunities in Listed Property
Listed real estate securities plunged in the June quarter of 2022 as interest rates rose. The decline looks too punitive, with several REITs now
at large discounts to net tangible assets, and our valuations.
The market seemingly fears a crash in physical prices, as rising interest rates inflate the capitalisation rates used to value property. Yet valuation news suggests that physical real estate values increased over the half year. Preliminary valuation increases were announced in June by major office and industrial REIT Dexus, and retail mall operators Vicinity Centres and Shopping Centres Australasia. Shopping Centres Australasia also purchased some retail assets from Centuria at a 24% premium to the value at which they were on Centuria’s books.
Capitalisation rates comprise a risk-free rate plus a risk premium. While risk-free rates are increasing on the back of central bank rate hikes, risk premiums are likely compressing as pandemic impacts fade. The net result is that cap rates remained fairly stable, and in some cases are lower than the end of 2021. We do expect some cap rate widening as interest rates rise further, but not to the extent implied by stock prices for many REITs. Furthermore, we expect an ongoing recovery in property income for many REITs, especially in retail and office.
Office is likely to benefit from ongoing recovery in CBD visitation, and leasing progress with major corporate tenants who procrastinated on
leasing decisions in 2020 and 2021. CBD retail should benefit from the same theme, and we expect the broader retail property sector to benefit from a gradual recovery in international tourism and the continued easing of pandemic impacts.
Residential property faces headwinds as price growth has reversed with interest-rate rises. However, the market appears too pessimistic on some REITs, notably Mirvac. It has a strong balance sheet and should benefit as from less competition as weaker rivals exit. We also see tailwinds from a recovery in population growth and the affordability advantage of apartments over houses. Its commercial property portfolio is in good shape, with long leases and high occupancy. Ryman Healthcare also looks undervalued, as demand for its product is likely to grow due to rising old-age dependency. Ryman refrained from increasing its retirement unit prices in line with residential property, so we don’t think it is exposed to the full brunt of any house price correction.
Investors Throw the Technology Baby Out With the Bathwater Causing Significant Undervaluation and Opportunities
The technology sector continued to bear the brunt of equity market weakness in the second quarter of 2022, with the Morningstar Australia
Technology Index, down 26% and materially underperforming the 14% fall for the Morningstar Australia Index (Exhibit 12a). Technology stock
weakness reflects the recent surge in inflation and ongoing rally in bond yields, with the Australian 10-year government bond yield increasing to 4.1% currently from 0.7% last October. Higher interest rates have a disproportionately negative effect on long duration securities, such as technology stocks, where the bulk of the expected cash flows are usually far into the future.
Technology stock weakness is disproportionately affecting relatively early stage and high-risk companies as investors reduce exposure to risk on growing fears of a global recession. This has caused particularly heavy selling of the relatively new financial technology companies, with EML Payments and Tyro Payments down 62% and 78%, respectively, in the past year. In contrast, established software firms with economic moats have fared far better, with Technology One up 13% over the same period.
Although technology company share prices have plummeted in recent months, Morningstar’s fair value estimates have been more stable and price/fair value estimate ratios have significantly improved. The average price/fair value estimate ratio of our ANZ technology coverage has fallen to 0.67 from 0.95 at the start of the quarter (Exhibit 12b). Our long-term investment theses for our technology stock coverage remain intact. While a recession may slow the strong expected growth for the sector, it’s unlikely to materially change the long-term trajectory of the sector as technological adoption continues. For example, we still expect Xero to significantly grow subscribers over the next decade (Exhibit 12c).
In the current risk averse environment, we expect investor sentiment towards fintech companies to remain negative until firms demonstrate long promised earnings growth. We expect Fineos, EML, Tyro, and Zip to rely on a combination of cost-control, product cross/up-sells, and horizontal integration to boost earnings. We expect fiscal 2023 will be a year when investors expect firms to deliver on long held promises.
High Power Prices Can Boost Utility Profits but Also Increase Risks
Australian and New Zealand utilities have a weighted average price/fair value estimate ratio of 0.98. Share prices for Australian utilities have
improved in the past six months (Exhibit 13a), while their more expensive New Zealand cousins have come back to earth, the New Zealand
companies are only included in the price/fair value estimate chart in Exhibit 13b and not the Australian Utilities Index in Exhibit 13a.
We’ve long expected Australian wholesale electricity prices would rise but this year’s rally has been breathtaking (Exhibit 13c). Electricity prices shot to extreme levels amid high fuel prices and power station outages, forcing the regulator to intervene in recent weeks. Unfortunately, there is no easy fix, and we estimate household utility bills are likely to rise 50% over the next few years as higher energy costs are passed through.
High electricity prices are a boon for AGL Energy, assuming its power stations work. Unfortunately, its ageing fleet suffered failures, forcing the firm to procure electricity from more expensive sources. With wholesale electricity prices well above the price AGL Energy can sell to retail and other customers, it is likely racking up losses on sales not covered by its own generation and hedging. This is likely to weigh on fiscal 2022 and 2023 earnings, but we expect much better profitability from 2024.
Gas pipeline owner APA Group’s revenue should accelerate on recent developments and higher inflation. About two thirds of revenue is linked to Australian inflation, which was 5.1% in March, and the balance is linked to U.S. inflation, which was 8.6% in May. Rising bond yields will put upward pressure on interest expense, though this should be muted by extensive interest-rate hedging. Overall, APA Group’s outlook is favourable, but it is now a little overvalued.
Reproduced from Morningstar Australia: Australia and New Zealand Equity Market Outlook: Second-Quarter 2022| June 24, 2022
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