What happened to Australian equity market outperformance?
Growth jitters and the possiblity of reduced iron ore demand in China have swiped the heavyweight banking and resources sectors.
Lewis Jackson: After months of outperformance Australian equities are reeling from a savage sell-off that's left the local index lagging peers in Europe and Asia. I'm joined today by Morningstar's Tim Murphy to talk through what's going on in Australian equities right now.
Tim, months ago, fund managers, analysts were talking about how the Australian equity market was uniquely positioned to handle these rising rates, this inflation that we're seeing around the world that's causing these massive sell-offs. That no longer seems to be case, but can you walk us though what was the case. Why were so many people so optimistic about the local market?
Tim Murphy: Well, there's probably two key themes driving that thought earlier in the year. If you think about the biggest make-up of the Aussie market sector-wise, it's obviously financials, big banks, as well as mining, resources and materials companies. And so, if you think about the banks and the view that inflation was starting to hit and interest rates are likely to go up. So generally speaking, a rising rate environment is positive for the net interest margin of banks, which is positive for earnings and so given the size of the Aussie market that the banks make up, that it was deemed to be a positive tailwind essentially for the banking sector.
On the resources side, obviously we've seen inflation really push through in many of the commodities for a variety of reason, accentuated then with the Ukraine situation and what's happened to energy prices as a result of that. And so, you saw a really rapid share price increases in many of those mining and energy companies off the back of that. And so, that thesis with the Aussie market dominated, while those two sectors definitely played out for the first few months of the year.
Jackson: And then what happens, if we look a chart of ASX 200, it's – I think at one point in April it was actually even for the year compared to the US down 10%, 15% and then come June, it falls off a cliff. Now rate started – the RBAs sort of really stepped up its rate hikes in June. Why wasn't that good news for the banks? And then what happened to the iron ore mine, what happened to the resources sector, the second leg?
Murphy: Well Certainly we've seen on the banking side with probably higher than expected increases from the RBA initially, that's definitely put a very quick dampener on people's growth expectation in the banking sector, particularly around new mortgages and whatnot, and so while the rising rates is positive for the net interest margin, if there is no or potentially negative growth coming out of the mortgage book, that's obviously a big negative for the Aussie banks given that's a biggest makeup of their business. And so, while the margin expansion is great, your negative growth obviously is not so great and so that's why we're seeing sort of market reacts to that as we've seen the RBA which has frankly been late to the party, finally, come on with some of the bigger official interest rate rises, playing a bit of a catch-up with central banks elsewhere in the world.
On the resources side, I think particularly, you mentioned iron ore. Obviously, we're seeing the lockdowns in China, from their latest COVID outbreak in recent months has really started to crimp economic activity in China, and so obviously they are our biggest customer for iron ore and so that's shrinking of demand there as well as what the outlook is for that, potentially, puts much more dampened expectations on future price increases there, and so what's probably led to more recent softness in those sectors here.
Jackson: And going forward, interest rate increases are showing no signs of slowing down. When you think about both of those legs over the next six months, were we too optimistic at the start of this year? What's your sense of what's going to happen going forward? If we just looked at China for example, the lockdowns are beginning to end. Is that good news for iron ore prices?
Murphy: That's, I guess the million dollar question. Isn't that? What does this sort of forward outlook look for China. I think the reality is most of us in the western world in some ways are just getting when it comes to that. We can have hypothesis and we can have thesis. And I think the reality is we need to look at different scenarios and not probably have all our eggs in one basket on any one scenario as to what that may means for demand – their demand for iron ore and other materials and how that then might flow through to the share price of those companies locally.
On the banking sector I think it really is, the action of the RBA and what it takes over the coming months will I think heavily dictate how the banks are likely to perform. There's obviously varying views on people's expectations about magnitude of interest rate increases has definitely risen, some of that's baked into prices now already and truly going to be driven by whether the RBA surprises on the up or downside in terms of what further increases they've got over the coming months. So definitely an interesting space to keep an eye on.
Jackson: And we've talked a lot about mining and a lot about banking, I guess the two pillars about Australian outperformance thesis. Were there other elements to it, is there anything, the other parts to this story that have unfolded in the last month or two that are getting – leaving investors a bit concerned?
Murphy: Well, I think certainly relatively to other markets around the world where you've seen the big growth, high PE stock unwind and obviously we don't have a large tech sector here compared to say the US which has certainly led to some of the relative differentials this year. In terms of more broad-based effect on sectors in Australia, it's really going to be case by case. Whether we end up in a recession or not, it's definitely going to affect or drive the relative under or outperformance of the domestic cyclical sectors. And so, having that view on whether we – how long – first of all how long inflation is likely to last, whether the RBA action is likely to lead to recession or not is going to dictate who the under and outperformers are going forward.