Australian equities

The S&P/ASX 200 Total Return Index returned 1% over the three months and 14.8% over the year to 30 June 2023

S&P/ASX 200 Accumulation Index cumulative return (Jun-22 to Jun-23)

Recommendation: Maintain underweight

Source: S&P, Bloomberg

Australian equities are facing a period of significant uncertainty amid a weak global and domestic economic backdrop. “Confession season” arrived early with several companies downgrading guidance for the financial year resulting in heavy share price declines with previous market darling, Domino’s Pizza, one of the more notable examples A slowdown in the global manufacturing sector and limited stimulus in China is likely to reduce demand for resources. Bank margins face challenges from heightened competition (reducing profitability) and rising arrears as interest rate hikes bite. Consumer sentiment remains near record lows, which bodes poorly for the retail sector that has benefited strong government stimulus in recent years.

Given these conditions, we believe there is further scope for earnings downgrades and heightened risk for further price corrections as economic activity slows. In conclusion, we continue to recommend investors retain an underweight exposure to Australian equities.

Our outlook for some of the major sectors of the S&P/ASX 200 is as follows: Banks

Recommendation: Maintain underweight

We believe the downside risks continue to outweigh potential upside factors and we retain an underweight position on the banking sector.

Our credit growth outlook remains negative. New mortgage loans (excluding refinancing) are down over 26% for the year to April

To attract customers in a weak market, lenders must be willing to sacrifice margin in the form of lower rates or cashback and other incentives. This has the impact of lowering net interest margins, which is less supportive of profitability going forward.

Credit quality still appears strong based on the latest bank reporting. However, as S&P figures show (see below chart) we are beginning to see the uptick in mortgage stress for mortgage-backed securities (RMBS) that they cover. In our view, bad debts are likely to increase over the next 12 months as heavily indebted households and corporates struggle to meet repayments. This may accelerate further if the labour market begins to weaken materially. An offsetting factor will be the value of existing property assets, which have held up better than expected (down only 2.2% nationally from their peak in March 2022 according to the ABS22) for the scale of rate rises thanks to a backlog of construction activity (reducing new supply) and stronger-thanexpected net migration over the past year (boosting demand). That backdrop has seen residential vacancy rates nationally fall to 1.2% as of May, a level not seen for over 15 years23 Taken together, these are factors that will continue to support property values and should provide a limit on how far loan losses might escalate helping avoid a potential “hard landing” scenario for major banks

SPIN RMBS arrears rate (Apr-03 to Jun-23)

Sources: S&P Global as of April 2023, Bloomberg

Lastly, on valuation, the picture becomes less clear. On the one hand if we look at the major banks, only one, Commonwealth Bank (CBA) is still trading at a material ~20% premium to its long-term median valuation. The others are trading at various discounts, reflecting weaker performance relative to peers in recent years

Major bank premium/discount to long-term Forward P/E ratio (Mar-15 to Jun-23)

Sources: Bloomberg

The question is whether enough weakness has been priced into their valuation given the outlook. The market consensus currently anticipates little to no growth in earnings per share for the period from FY23 to FY26

Source: Bloomberg as at 26 June

22 Total Value of Dwellings, ABS, March quarter 2023, https://www.abs.gov.au/statistics/economy/price-indexes-and-inflation/total-valuedwellings/mar-quarter-2023

23 National Residential Vacancy Rate, SQM Research, May 2023, https://sqmresearch.com.au/graph_vacancy.php?national=1&t=1 https://sqmresearch.com.au/graph_vacancy.php?national=1&t=1

Historically this has proven to be an opportune time to gain exposure to the banks. However, risk remains skewed to the downside. We believe it is still too early to form a constructive view, given recession risks are rising. One upside risk is the potential change to the RBA Governorship, which could see a more dovish monetary policy stance supporting the banking sector.

Recommendation: Maintain underweight

Iron ore prices declined almost 21.8% from the end of March to late May. However, they have since rallied almost 14.7% from their lows to only be down 10.4% for the quarter to date (as of 21 June). Chinese industrial data disappointed with industrial production up 5.6% for the year to April (consensus: 10.9%)24 , while credit growth has similarly been below expectations with aggregate financing, a broad measure of credit, at 1.6 trillion yuan for May (consensus: 1.9 trillion yuan)25 contributing to a negative outlook for iron ore prices. While there is speculation for further stimulus from Chinese authorities, actual official announcements have been muted to date

In addition, we are still yet to see a material credit bounce out of China. The Chinese credit impulse (blue line below), a measure of new lending being generated within the Chinese economy has tended to be a leading indicator for the likely trajectory of industrial metal prices. This is because the new lending activity has tended to see large scale investment projects in property and infrastructure within China that require substantial metal imports to build. As we can see below, the credit response has been relatively muted in recent months suggesting limited impetus for prices to climb further from current levels.

Industrial metal prices versus China Credit Impulse (May-13 to Nov-23)

Source: Bloomberg

Forecasts for the broader global economy remain anaemic in 2023, a decidedly negative prospect for resource demand with some countries, such as Germany entering technical recession already in the March quarter Limited relief on the interest rate front will continue to challenge demand and make it more difficult for investment projects to proceed due to higher borrowing costs. The outlook for manufacturing also appears muted, which should weigh on commodity demand.

Taken together, we believe the significant headwinds to global growth amidst still hawkish central bank policy continue to subdue demand for key commodities such as iron ore, copper, oil and gas. Accordingly, we maintain our resource sector underweight.

24 Disappointing activity data in China suggests more fiscal support is needed, ING, 16 May 2023, https://think.ing.com/snaps/chinadisappointing-activity-data-means-suggests-more-fiscal-support-needed/

25 China Credit Demand Weakens In Fresh Sign of Waning Recovery, Bloomberg, 13 June 2023, https://www.bloomberg.com/news/articles/2023-06-13/china-credit-demand-weakens-in-fresh-sign-of-waning-recovery#xj4y7vzkg

Consumer spending has remained soft with retail sales volumes barely positive, rising only 0.2% for the year to March 2023. Commonwealth Bank’s proprietary Household Spending Intentions Index, a timely retail spending indicator, has also weakened into the June quarter.

In addition, a long-standing measure of consumer demand, the Westpac-MI Consumer Sentiment Index continues to track at depressed levels with the latest RBA rate hike and inflation weighing on households. One area that had been consistently positive, jobs prospects, is now weakening as well with the Unemployment Expectations Index rising 6.6% in June and 32% since the RBA began hiking in May last year Westpac-MI Consumer Sentiment Index, 6-month average (Jun-93 to Jun-23)

Source: Bloomberg

Lastly, the share price index for listed consumer discretionary stocks fell by 3.9% over the quarte on the back of several high-profile downgrades including names such as Baby Bunting, Adairs and Super Retail Group26

The risk of further downgrades remains high because earnings, boosted by record stimulus and household savings from the pandemic period, remain elevated relative to the historical trend

This can be demonstrated in the chart below, which shows cumulative EPS growth of over 40% on average since December 2019 for select retailers. As savings buffers unwind, we expect retail earnings to normalise towards pre-pandemic levels since wages have only risen 8.2% over the same period27

Cumulative growth in Forward EPS for select retailers (Dec-19 to Jun-23)

Source: Bloomberg

26 Best & Less reveals Australia’s spending pain, and there’s more to come, Australian Financial Review, 20 June 2023, https://www.afr.com/chanticleer/best-and-less-reveals-australia-s-spending-pain-and-there-s-more-to-come-20230620-p5dhvd

27 Wage Price Index, seasonally adjusted excluding bonuses, private and public sector, ABS, Dec-19 to Mar-23, https://www.abs.gov.au/statistics/economy/price-indexes-and-inflation/wage-price-index-australia/mar-2023

Recommendation: Maintain underweight

The AREIT universe underperformed the broader market in the June quarter One driver was the impact of rising interest rates for sector profitability. REITs face refinancing risk as their borrowings mature and must pay at higher rates, which reduce earnings. In addition, some are financed with floating rate debt that reprices more instantaneously and has an immediate impact on profitability in a rising rate environment.

In addition, many REITs in the low inflation environment opted for fixed rate rental escalation as opposed to inflation indexing. This means that rents have lagged rising input and financing costs.

In some segments, the demand outlook has softened further with retail REITs the worst performers in the quarter, led by the likes of Vicinity (VCX, down over 13%) and Westfield landlord Scentre Group (SCG, down over 10%). Rising rates drove weaker investor sentiment as concerns over consumer spending mount in the face of harsher financial conditions

Numerous office property trusts have been trading at significant discounts to their stated book values. This disconnect has started to narrow as recent transaction activity has seen property valuations fall. As an example, Dexus (DXS) sold 44 Market St, a Sydney A-grade office property, for $393.1m, a 17.2% discount to its Dec-22 independent valuation. This is materially less than the current 30%+ discount that Dexus shares trade at. It does suggest however that unlisted property trust prices are inevitably revised lower as their assets reflect current market pricing.

There is a growing concern that falling asset prices could see property trusts breach lending covenants. Dexus (DXS) is one of the best placed to weather this potential risk as highlighted below, able to easily absorb a 25% decline in asset value. By contrast, a range of other property trusts could breach with as little as a 10% decline, such as Charter Hall’s Prime Office Fund (CPOF)

Office real estate Funds - Debt sensitivity to falling asset prices as at 31 March 2023

Source: S&P Global28

Another issue for the office sector is the challenge for lower grade buildings which are facing both high vacancy rates and increasing supply. The below chart neatly illustrates this with higher quality prime office properties continuing to see positive net absorption (i.e. increased take up by tenants). Meanwhile lower quality, secondary sites continue to see supply growing, an unfavourable dynamic that places downward pressure on rents. 28 Prime Assets Will Help Shield Australia’s Office REITs From Rising Stress, S&P Global, 29 May 2023, https://www.spglobal.com/ratings/en/research/articles/230529-prime-assets-will-help-shield-australia-s-office-reits-from-rising-stress12741579

Source: Dexus, Macquarie Australia Conference presentation29

In conclusion, A-REITs have struggled over the past financial year with rising interest rates weighing on the sector, leading it to be the worst performer in the ASX. We believe the sector remains challenged given the above factors and would need to see a sustained decline in interest rates or stabilisation in asset values to improve our view Accordingly, we maintain our underweight outlook.

By Cameron Curko, Head of Macroeconomics & Strategy | Pitcher Partners

Sydney Wealth Management

+61 2 9228 2415 cameron.curko@pitcher.com.au

29 Macquarie Australia Conference presentation, Dexus, 2 May 2023, https://newswire.iguana2.com/af5f4d73c1a54a33/dxs.asx/2A1446960/DXS_Macquarie_Australia_Conference