The Cameron Harrison Australian Equity Strategy operates across three allocation themes of large cap, mid to small cap and financials. This provides discrete and dynamic allocation, particularly given the skews that exist in the Australian equity market. Our purpose is to generate a consistent balanced long-term return, combining income through dividends and capital growth. We achieve this through investing in listed businesses that exceed in terms of financial health and our ‘business success framework’ which evaluates strategy and its effective delivery. Our equity management operates within an overall framework of risk amelioration which ‘underpins’ the primary hallmark of capital preservation.    

The key factor driving asset class returns in 2023 and into 2024 is central bank tightening to curb inflation. Bonds have performed very poorly whilst equities in relative terms have performed better.  Our view for the Australian economy is that the economy will go into recession in 2023. We think signs of economic pullback will become evident in early 2023. The household sector is now in significant restrictive economic territory and increases in unemployment will begin to be observed (but without the severe job loss pain of the early 1990s). The shift in restrictive policy will begin in 2H2023. It is an environment for bond yields to decline and equities earnings to come under pressure. We do stress however that whilst we do see central banks getting on top of inflation, inflationary pressure and a higher level of interest rates than otherwise existed over the last 12 years will exist.   

Earnings estimates we view are too optimistic. We expressed this view in ‘Have equity markers skipped the earnings revisions?’ (Aug 2022). Whilst there have been moderate declines in estimates, markets certainly favour a benign economic contraction. Whilst we think that is true for absolute levels of labour, the domestic economic environment led by the household stands to deteriorate significantly through 2023 impacted by a reduction in house value wealth and constricted finances. 

Even before the lagged impact of mortgage rate increases has taken effect, we can see below that the bounce back in real spending from COVID has been funded by savings drawdown. The combination of savings drawdown and negative real wages growth in combination is a drag on activity and illustrates households’ spending rates are approaching a decline as savings are dissipated. This is important to moderating Domestic Final Demand which was running at 6.9% for the 12 months to 30 September 2022.  

From a valuation perspective, the Australian equity market is not illustrating stressed valuation. On many varied metrics such as equity premium and cyclically adjusted price-earnings (CAPE), the equity market is demonstrating fair value. We would agree with a higher equity risk premium (excess return investors require over bonds) is valid. Below we can see it has been declining over the last 20 years at the same time bond yields have been declining. The forward environment indicates higher inflation and volatility which in turn, supports a higher risk premium. 

Below we can see the current cycle adjusted price-earnings (CAPE) to expected 10-year nominal equity returns. This indicates earnings multiples are not at elevated levels and are generally supportive of equity markets moving forward over the medium term. The proviso is short-term cyclically impacted earnings does however need to be taken into account.

The materials resource sector is experiencing significant profitability, and this is attributable to elevated prices (which is reflected more broadly in historically high terms of trade). The volume impact is negligible, and reflects a more controlled capital investment cycle since the mid 2010’s. Whilst China reopening post-COVID restriction loosening is positive as is Vale’s slow progress to get iron ore production back to levels pre the dam disaster, we see a reduced demand profile out of China.  

Elevated Terms of Trade delivers extraordinary price performance for Australian exports, particularly those most exposed to spot markets such as iron ore and coal. 

Mining investment (ostensibly in new production) has collapsed over the last 8 years, delivering significant leverage for the large producers. Basically, capital expenditure is just meeting stay-in-business depreciation. Instead, corporate activity into existing production or known resources is the preferred growth strategy for the large-cap producers. This is apparent with two of our portfolio positions in BHP and Oz Minerals and their agreed scheme of arrangement. 

A major factor in corporate profit margins is the cost of labour. Our labour market, like other developed economies, is facing elevated inflation and its corrosion of real incomes. This combines with a tight labour market, which for Australia is largely attributable to the decline in temporary visas through the COVID lockdown (and permanent arrivals) and departures. We are cautiously optimistic of a return to significant visa arrival numbers through 2023 which we think will assist labour supply and dampen wages pressure. 

Whist substantially higher immigration has a dampening effect on wages, reduces inflation expectations and aids the RBA in its inflation ‘flight’, labour remuneration as a proportion of GDP is low (and profits to GDP are conversely high) – this is both on a relative basis to other developed economies and historically for Australia.

Further, we view recent changes to industrial legislation and the historically high level of tax taken through ‘bracket creep’ as pressures on wage remuneration and corporate profitability. Businesses need to be adept and ahead of the curve in managing their pricing policies to mitigate the impacts of cost pressures. In the medium term, we think it may also see business increase their capital investment plans to drive efficiency and cost efficiency.  

The last 30 years has been one of Great Moderation economically, geopolitically and in social cohesion. This saw monetary policy take the lead in forward policy, and fiscal policy take more of a back seat. We consider the period of Great Moderation finished. In its place, we see less coordination, greater economic nationalism, increased controls, but above all, greater government involvement.  Governments are emboldened due to their COVID response, together with the community’s general support for net zero emission targets and bipartisan support for increased defence spending. These are factors which cause us to assess that interest rates will be higher than in the last 10 years.   

Banks matter a lot for the Australian Equity market. Australian banks represent twice as much of our market capitalisation compared to the world ex-US and a significant, four times more than the US equity market. We have long held that this creates undue capital distortions and equity concentration risk. Banks are managing a tightrope of improving their net interest margin (NIM) balanced to economic contraction impacting household values and potential unemployment. Against cycle provisioning, rising operating costs and higher funding costs in 2023, we view banks as being peak and priced for perfection (in an environment which is far from perfect).   

In summary:

• We are broadly comfortable with risk metrics for Australian equities, however…

• That there will be a contraction in economic activity to some degree, which will invariably result in earnings weakness in various segments

  o   Businesses have been adjusting to supply side and labour cost price increases, but will now need to contend with domestic demand contraction

  o   The household sector will provide the major break on domestic activity as rapid and painful adjustment to household finances takes hold.  

  o   We would note that whilst increased unemployment is likely, economic contraction is not likely to result in wholesale, deep unemployment  

• Banks have headwinds during 2023 and the current environment sees them favourably valued despite impending margin pressure, costs pressure and loan impairments increasing. This is reflected in a reduced allocation

• Resources in the medium term stand to benefit from the net zero emission transition. In the short term, the bulk commodity segment is reasonably placed in terms of supply (together with Vale’s continued production problems) but the demand benefit of China reopening post-COVID is quite unclear and not convincing. A balanced portfolio of resource exposure is preferred.

• Capital market elements will look more favourable in 2H2023 as we think the RBA will have reason to pause (and then turn), and wages growth will be crucial, and we think immigration arrivals (temporary skilled/student) is important – this provides a  sound backdrop for equities but non-discretionary, cyclical exposure which will struggle for the greater part of 2023 and through 2024 as households (and the real economy) adjust.