Emma Rapaport: Hello and welcome to Morningstar. I'm Emma Rapaport. Today joining me is Gareth James. He is an equity strategist in our equity research team here at Morningstar. He's joining me today to talk about the quarterly outlook for the Australian equity market.

Gareth, thank you very much for joining us.

Gareth James: Thanks, Emma.

Rapaport: Gareth, in your report, you've talked about that the market is or the ASX 200 is even more overvalued than it was in the previous quarter. You said it's now 15% overvalued with only one sector in the undervalued range. Why did we see such a jump in the markets in the last quarter?

James: Yeah, so I think what we've seen in the quarter that we've just had is, interest rates have fallen back a little bit. So what I mean by that is, if you look at the 10-year Australian government bond yield, that yield has fallen back a bit. And I think what we've seen is a bit more of an increase in risk tolerance by equity market investors. So we've seen sectors like the technology sector, for example, which is a high-risk sector have a very strong rebound in the second quarter of the calendar year. And I think we've seen that reflected in other sectors of the market as well. So, overall, the market has continued to power higher. And from a price to fair value perspective, that's meant that equities, in our opinion, have become more expensive.

Rapaport: There seems to be this obsession with interest rates. Can you explain why people are so interested in where interest rates are going to head, both in Australia and overseas? And why also you think rate rises are still some way off?

James: Yeah, so interest rates are really important to equity market investors, because the cost of capital or the cost of money is the most fundamental driver of equity market valuations. So as interest rates rise, yields on equities have to rise. And the way that that happens is by prices falling, and vice versa. So as interest rates fall, the required rate of return from equities falls, so you know, you can afford to pay a much higher price for equities. So interest rates are really important to the value of all assets. And what we've seen recently is, you know, real estate in Australia is incredibly hot at the moment prices are rising very quickly. And I think that's really due to very low interest rates. Now, the key question going forward is what happens next, considering that the risk-free rate or the Reserve Bank of Australia's interest rates, the target cash rate has basically hit zero. So most people think that interest rates are going to have to rise at some point.

But I think what's bearing in mind is that the RBA has a target range for inflation, which is 2% to 3%. And the RBA has said that, to hit that range, wage growth is going to need to be over 3% sustainably. Now that looks pretty challenging, which is why the Governor of the RBA has said he doesn't see interest rates rising until at least 2024. And we think that that's probably likely to happen. Now, lots of people are getting quite excited about interest rates moving up sooner than that, because of what's happening in the unemployment market. So unemployment is falling much more quickly than most people expected. And that creates the possibility that wage growth is going to accelerate. But at this stage, we're saying, well, let's wait and see, because we've still got -- the national border needs to reopen, which will mean an increase in population. And we'll also have temporary migration so students and backpackers will come back to Australia at some stage and that will put upward pressure on the unemployment rate.

Rapaport: So with markets appearing so overvalued, in your view, what do you see as the biggest risks currently in the market?

James: Yeah, I think the big risk is that investors are extrapolating the current environment for interest rates. So they're not fully appreciating that over the longer term, it's highly unlikely that we're going to stay at these levels around 0% interest rates, right. Now, if that happens, as we expect, then the price to earnings ratios that we see on equities are likely to fall. So the real risk is that we're going to see a rerating of P/E ratios in the market. And that will be a big headwind as we go forward. And I think that there's kind of an underlying issue there, which is one of inflation, right. So I think the really big risk is that we have a big increase in inflation, which isn't what we're expecting. But I'd say that is somewhat of a risk. And that would be largely driven by the quantitative easing, or the money printing that we've seen, which hasn't yet driven, particularly strong inflation.

Rapaport: So all eyes on the RBA for now.

James: Yeah, that's right.

Rapaport: So if we turn to some of the sectors within the report, the sector that you cover, the IT and technology sector is currently the most overvalued. And I assume that that's a reflection, of course of the inflation concerns you were just talking about. But can you explain why that sector is the most overvalued compared to even consumer discretionary?

James: Yeah, sure. So with technology stocks, what tends to happen is they tend to be growth companies, right. Particularly, in recent years, we've seen the emergence of lot of growth companies. And that creates a number of issues. I think the first thing is that the earnings are far out into the future, right. So those stocks can be very sensitive to interest rates. So as interest rates fall, their valuations, the valuations that you can justify, can increase quite significantly. And the other thing is, is that we've seen some very successful technology stocks in recent years with regards to valuations. And then we've seen a kind of a bull market in technology stocks for a few years, where investors tend to forget that stocks do go down sometimes.

Now, I think that the risk is, that these technology stocks that aren't making any money are arguably quite vulnerable to disruption. Because in the technology sector, you often see new new companies coming out and replacing older companies. So, there's a big risk with those kinds of companies, those companies that aren't making any money, potentially never make much money, right. Now, if that situation eventuates, then you have a situation where you have a massive derating of the share prices. And what we saw in the year 2000 tech bubble was that all of a sudden, the whole market wakes up to the reality that, technology company doesn't have a licence to print money, and technology stocks do go down, and then you kind of have a rush for the exits, and you have this big crash. So I think that's one of the risks in the technology sector. And from our perspective, we're just trying to take a rational approach and stick to, what we think is likely profits going forward rather than what we think a stock can trade on, just because another stock is trading on a particular valuation.

Rapaport: And if we flip to the other side, we talk about the energy sector, which you say is the most undervalued. I found this surprising considering that there was a big jump in the energy sector at the end of last year. Why do you think the market is continuing to undervalue or under appreciate stocks within the sector?

James: Yeah, it's an interesting situation. I mean, if you remember, last year, we had a situation at one point where the oil price actually went negative, which is a bit of a confusing concept. But that's to do with the way that the oil market works. And what we've seen since then, is we've seen the oil price come back incredibly strongly. But energy stocks haven't come back as much. Now, that's kind of a classic situation where we think that there's value in those energy stocks, because we think there's further to go and the oil price is indicating that there's further to go.

Rapaport: And just finally, I think, when I read this report, I don't get the takeaway, that, you know, everything is overvalued, and you should rush out and sell everything, you do say that there are still some opportunities in the market. Can you just give us a quick highlight of some of those opportunities that you see?

James: Yeah, sure. So, in the course of the outlook report, you know, we've got in every single sector that we look at. We've highlighted three companies in each sector that we think are either undervalued in an absolute sense, or relatively undervalued. So, you know, if you look at, say, consumer staples, we've got a couple of stocks in there. Out of the three stocks that we've chosen, which have 3-star rating, which is a fairly valued rating, right? So it's not a 4 or 5-star, but we think, you know, there, if you're going to invest in that sector, those would be the stocks to go for. And so yeah, I'd absolutely recommend people refer to the report and the list of stocks. It's quite a long list of stocks. I mean, if you look at say the information technology sector at the moment, we are recommending Link Group, which owns the recently -- owns 43% of the recently listed PEXA. We're also recommending TechnologyOne and Computershare.

You know, but we've got a big list of stocks in the document. I'd also recommend people have a look at the best ideas list as well, which is kind of a subset of this longer list. And the best ideas list is a list of around 10 companies, which we think are particularly interesting opportunities. But yeah, I mean, if you're looking to allocate capital on a sector by sector basis, then the quarterly outlook report is a good place to start.

Rapaport: Excellent. Okay. Thank you very much for joining us today.

James: Thanks, Emma.