A market rally early in the quarter was touted, on hopes of a peak in inflation and interest rates. This has since fizzled out, according to Morningstar’s latest outlook. Inflation in August stood at 6.8% and on our central bank’s assessment, is likely to peak close to 8% by the end of the year. With major headwinds, Morningstar analysts believe that the bear market in stocks may continue.

At the same time fears of a global recession continue to cast a shadow on the local economy. AMP Capital chief economist Shane Oliver believes that the uncertainty about a recession remains high. Oliver, who will be speaking at the upcoming Morningstar Investment Conference for Individual Investors, acknowledges that from a macro perspective the risks are most likely still on the downside, at least in the short term as central banks remain hawkish. The Ukraine conflict has only added to the challenged outlook.

However, Oliver sees shares providing reasonable returns on a 12-month horizon as valuations have improved, global growth ultimately picks up again and inflationary pressures ease through next year allowing central banks to ease up on the monetary brakes.

Similarly, Morningstar analysts believe that the market is undervalued on a long-term view, and on their latest assessment all sectors of the Australia market are now fairly valued or undervalued. Indeed, about 14% of stocks in are trading below Morningstar’s fair value compared with 10% in early January.

Assessing the opportunities

So where are the opportunities? Technology, real estate, and energy are most undervalued. The report’s author Adrian Atkins recommends investors have a bias toward lower risk and moat stocks.

The technology sector’s relative underperformance during the year has been the result of its higher sensitivity to changes in interest rates. This is because, tech companies, especially those in earlier stages, often push out their profitability by reinvesting heavily into sales and marketing and R&D. As a result, the bulk of their expected cash flows is usually far into the future, which makes them especially sensitive to changes in the risk-free rate

It is important to be selective in the technology sector, especially in a potential recessionary environment. New businesses as ZIP Co (ASX:ZIP), could come under pressure during recessions. They may not have as much capital funding (as they did before) to drive growth, which increases the risk of market share loss. Variable costs, like interest and bad debts, would rise too while demand for lending would need to be spurred on by higher marketing expense.

Growth-stage companies, such as WiseTech (ASX:WTC) on the other hand, are likely to do much better during a recession as their revenue is mostly recurring in nature. Indeed, WiseTech is among Morningstar’s top pick in the technology sector.

Listed real estate security prices have plunged in 2022, and the fall continued in the September quarter as interest rate and inflation fears intensified.

Many REITs now look cheap, though some names carry very high debt. Again, investors will have to be selective, particularly as this sector confronts a market of rising interest rates. Top picks for Morningstar include Mirvac Group (ASX:MGR) and Charter Hall Group (ASX:CHC).

Energy markets are still beholden to the Russia-Ukraine war. However, in its assessment, Morningstar has noted that war-fuelled earnings are likely peaking but at the same time. Companies with export natural gas exposure, such as Woodside (ASX:WDS) and Santos (ASX:STO), have benefited most. These businesses have been able to eke out extra LNG production for delivery outside contract and into premium spot prices. Woodside is noteworthy in this regard with the highest proportion of LNG sales into this premium spot pricing. Indeed, Woodside is also a Morningstar top pick.

But just as there are opportunities, investors also need to be mindful of being choosy in down markets. Morningstar analysts sees most potential downside in firms with heavy debt, those exposed to discretionary spending and housing, and those on high P/E multiples.

Furthermore, Atkins also notes that the outlook remains risks with a potential for near-term downside as higher rates flow through the economy. Which is why, sticking with lower risk and moat stocks will be important.