Equities rally, but can Australia break its underperformance trend?

Australian equities hit a fresh all-time high last week amidst a continued global equity rally.

While the Australian equity market has performed solidly in an absolute sense over the past 12 months, delivering a total return of 11%, it has lagged the global equity market and indeed Australia has underperformed most of the major equity regions.

Figure 1: Australian equities have lagged much of the world over the past 12 months (total A$ returns)

The relatively small size of Australia’s IT sector and our disproportionately large weighting to resources (predominantly mining) have been key factors behind Australia’s relative underperformance over the past year.

Australia’s other key sector, financials (mostly banking), has outperformed the local index – although financials have been an underperforming sector when compared to the overall performance of global equities.

Figure 2: The local IT sector has performed well, but represents only a small part of our index

Australian equities lift on hopes of an improved cyclical outlook

Last week saw the release of Australia’s December quarter GDP figures, which confirmed that overall economic growth has slowed to a crawl.

Quarter-on-quarter GDP growth was only 0.2% in real terms. On a year-on-year basis, real growth was a “below trend” 1.5% with nominal GDP growth coming in at a modest 4.4%. While “better than feared”, the earnings growth picture coming out of the just-completed reporting season was even more sombre. It indicated that FY24 earnings growth is expected to contract by around 5%, with resource sector earnings growth particularly weak.

With such a mediocre growth backdrop, why has the local market been pushing consistently higher in recent months? Undoubtedly the strong rebound in US equities is helping buoy virtually all equity markets, including Australia.

Global investors are encouraged by signs that inflation is decelerating, leading to expectations of Fed rate cuts around the middle of this year. At the same time, economic and earnings growth is holding up better than feared, particularly in the US. These macro trends are helping risk assets across the world.

Over and above this promising macro backdrop, US tech has been turbocharging the performance of the US market. That's due largely to its outsized tech weighting and the perception that the US tech megacaps will be the principal beneficiaries of AI applications.

Australia has seen some benefits from AI in terms of the strong performance of the local IT sector and select “second derivative” plays. But the AI impact for Australia has been modest in terms of its capacity to lift the market. The local market is lifting more on the basis of an expected pickup in economic and earnings growth in 2025 as policy is eased.

Figure 3: The market is rising and rerating on the prospect of lower interest rates

The clearest manifestation of this optimistic cyclical view is evident in the performance rebound within the domestic banking sector. The consumer/retail sector is also showing improved performance.

We agree with the market's assessment that growth should improve as interest rates are edged lower through FY25. The prospect of 1 July tax cuts is another positive support for economic growth.

Holding back our return expectations is our view there is a fair bit of optimism priced in for a growth recovery, particularly in respect of the banking sector. However we do see improving prospects for economic and earnings growth over the next 12 to 18 months, so we see overall market prospects as reasonable.

The structural outlook for Australia – Can Australia break out of its underperformance trend?

Beyond the prospect of an improving cyclical outlook for market earnings, structural prospects for overall market earnings continue to appear relatively muted. This is principally because of the dominance of banking and mining (mostly iron ore mining) in respect of Australia’s cap-weighted earnings base.

This has already weighed on Australia over the last five to 10 years, however, it is likely to become even more of an issue over the coming five years. Australia has delivered significantly less earnings growth relative to the US over the last five and 10 years, with the tech sector lifting US earnings significantly.

It is also interesting that Australia has delivered less earnings growth than the world (excl. the US) over this period. Indeed, Australia has lagged both Europe and Japan in terms of earnings growth performance.

This reinforces the idea that stock and sector composition is more important for market earnings growth over the long run than local GDP growth performance.

Figure 4: US earnings growth has outstripped Australia which has also lagged the Rest of World (EAFE)

Australia does trade on a significantly lower PE multiple than the US, so Australia is likely to be more insulated from a US valuation correction if it does occur. However, Australia still trades on a moderate premium to Europe and Japan, despite less earnings growth historically (at least in terms of the last five to 10 years).

Figure 5: Key equity market valuation and earnings metrics

Australia – Cyclical lift amid longer-term headwinds

In summary, we see the cyclical outlook for Australian equities as reasonably constructive due to the prospect of improving earnings growth as the domestic and global economy pick up in response to lower interest rates. The performance of Australia’s mining sector remains something of a wild card with the prospects for the iron ore price seemingly tilted to the downside as the capital intensity of China’s growth model shifts down.

Figure 6: Australia's sector mix is dragging on overall earnings growth prospects

This uncertainty around the big miners, combined with likely structural headwinds for banking, suggests an active portfolio approach is needed to lift portfolio earnings growth over and above the market index.

While the Australian market appears constrained over the medium to longer term, full US valuations and an undervalued A$ leads us to a neutral view on Australian equities versus the world on a 12-month view. We will continue to assess relative market prospects over the coming months.

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