Chunks of the Australian equity market are well positioned to weather the destabilising forces unleashed by rising inflation, according to new research from Morningstar.

The heavyweight financial services and basic materials sectors are among the ASX sectors least vulnerable to the four horsemen behind this year’s record market selloff: inflation running at a multi-decade clip, central bank rate hikes, tightening valuations and recession storm clouds, according to a report published late on Friday.

“Cost-of-living concerns and fears of recession are growing, but Australian equity investors shouldn’t panic,” says report author Gareth James. “Many Australian listed firms have negligible exposure to, or benefit from rising inflation and interest rates.”

Australian equities suffered their biggest one-week loss since the pandemic last week, erasing months of outperformance amid a savage rout in global markets. Local equity market bulls have long argued Australia’s booming natural resource sector and oversized banks are a recipe for outperformance in a world of rising rates and soaring commodity prices.

James echoes this position arguing markets are overreacting to the macroeconomic storm clouds and that dire predictions about a recession and runaway inflation are unlikely to eventuate in Australia.

Australia’s economy is “in good shape”, growing at record rate in the first quarter and boasting a near 50-year low in unemployment, he says. His base case sees the economy avoid a recession, in line with the latest forecasts from the Reserve Bank and Treasury Department.

While higher prices are set to persist through this year and next, inflation should begin receding over the medium-term as energy prices plateau, global supply chains reknit themselves and wage growth remains modest, he adds.

“For inflation to be maintained, and prices to continue rising at the same rate, the drivers of inflation need to continue to change at the same rate,” he says.

Resilient sectors

The report ranked each of the eleven ASX sectors according to how vulnerable each was to the impact of rising prices, higher interest rates, an economic slowdown and a fall in valuations.

Financial services are best positioned, with banks set to benefit as rising rates breath life back into margins shrivelled by the long cash rate decline. Having only grown modestly in recent years for the sector should avoid a sharp compression. While a recession risks a jump in bad in bad debts, James believes a serious downturn remain unlikely.

Wide-moat Westpac Banking (ASX: WBC) is the top pick in the sector, trading at a 32% discount to fair value with a medium uncertainty rating that implies analyst conviction in the price target.

Commodities have historically held onto value during inflationary periods, bolstering the basic materials and energy sectors even as rising rising raw material prices boost revenue, says James. Years of supply discipline has left both sectors with low debt levels and mostly insulated from rising rates, the report adds.

“We also expect an Australian recession to have little impact on commodity producers due to the global nature of their businesses,” says James.

Woodside Petroleum (ASX: WDS) and agricultural chemical maker Nufarm (ASX: NUF) are two picks positioned to shrug off the challenging macroeconomic backdrop.

Healthcare companies share the resource sector's light debt footprint while the essential nature of health means higher prices can often be passed through without seriously reducing demand.

Narrow-moat Ansell (ASX: ANN), a world leading provider of protective equipment, is a Morningstar best idea and should sidestep the worst of inflation or rising rates, according to the report. Shares are trading at an 33% discount to fair value.

Real estate and communication services are most vulnerable to the inflationary shock and a slowdown in growth. Higher debt levels make profits in both industries more sensitive to a higher cash rate. A recession would crimp advertising demand for media companies and slash foot traffic and activity across retail, industrial and commercial real estate.

Narrow-moat TPG Telecom (ASX: TPG) and no-moat Lendlease (ASX: LLC) are among the most protected plays in the sector.