Is 2024 the year for a hard, soft or no landing?

As the world continues to settle into more ‘normal’ long-term interest rates, long-term inflation expectations, and a probable contraction in household budgets, our outlook highlights how carefully selected Australian equities can provide investors with attractively valued income and growth opportunities. We also reiterate the importance of a balanced approach to portfolio management to navigate what may be a choppy macro-economic ocean over the coming year.

Key economic and market themes driving our 2024 outlook

Services resilience provides global growth uplift

Most growth indicators have pointed to a slowing global economy since late 2022 because of higher rates, less fiscal stimulus and the drag from high inflation readings.

The Global Manufacturing Purchasing Managers Index (PMI) has historically been highly correlated to the global EPS cycle and is pointing to recession.

A consistent theme of late has been sequentially lower core US CPI increases. This has allowed bond markets to rally and the Fed to shift to a more dovish stance. However, despite the apparent contradiction of peak rates and inflation in the US, consensus forecasts still have US EPS improving in 2024 – driven by the “Magnificent Seven” tech stocks. Notably, we have seen that the PMI for services (rather than goods) has been surprisingly resilient and has contributed to the bounce in these expectations since March 2023.

Australian slowdown despite high savings buffer

The rise in domestic short rates has worked to slow local GDP growth, particularly on a per-capita basis. This has manifested into weaker household consumption, the worst since COVID, however, it is holding up relatively well given the ability of Australian households to continue running down savings.

Data published by the CBA’s chief economist shows there is still a way to go to fully work through this COVID-fuelled excess savings pool. The saving ratio is still mildly positive, which means that the stock of savings is still actually rising, albeit at a slower pace in recent quarters.

Domestic economic stats continue to deteriorate

Whilst the Government’s budget and export surplus do remain strong, many other aspects of the national accounts have continued to deteriorate.

In the latest data release, nominal household disposable income slowed to near the weakest in decades, dragged by higher tax, and RBA rate hikes lifting household interest payments to a record high quarterly level.

While inflation has finally begun to show signs of slowing after 13 rate rises, it’s still high vs. history, and expected to stay higher for longer. Wage growth hit decade highs, while productivity recovered slightly but remains around the lowest level since 2016. The terms of trade have also fallen to the lowest level since 2021.

Australia profits expectations continue to hurt

Australian profit growth expectations have trended down with Global PMI, with consensus profit forecasts for the year ahead showing a modest 3% growth. Resources and Financials are the main growth inhibitors, while growth pockets do reside in the Real Assets, Industrials, and Insurers within Financials.

How the Australian economy lands is critical

In 2024, we see that macroeconomic data will remain subdued, and rate cuts and easing inflation will likely be required to offset the continuing weakening state of household finances.

The shape of the landing, be it soft/hard/none, and the degree of further compression in demand indicators relative to persistent cost pressures such as wages, will be critically important for company profits.

Further resilience in employment may support the soft-landing thesis established in recent market action.

Expectations for earnings and dividend growth

Robust balance sheets and pricing power

Unfortunately, the outlook for dividend growth is dominated by this poor earnings growth outlook, even though Australian company balance sheets are generally strong and payout ratios are modest versus history. As a result, being selective in stock picking for income and growth is as important as ever.

We expect that higher-quality, more defensive businesses that have pricing power to pass through inflationary impacts into their revenue stream will be better placed to grow dividends in the current environment. We note that inflation-linked mechanisms can often take time to flow through to revenues, so we see that positive impacts of past inflation can benefit returns for some time after inflation does slow.

Rates to impact Financials in 2024

Financials generally weathered the steep hiking cycle relatively well in 2023, but 2024 may be harder.

Banks impacts are nuanced. Initially in 2023, poor economic growth and falling house prices – which in turn can affect bad debts – were being balanced against positive rate impacts on net interest margins. Banks did enjoy strong deposit margins initially, however much of this was squandered on mortgage discounting, which is now causing declining pre-provision earnings. Macro relief has ensued, but looking forward we believe banks still face further deposit margin adjustment, and whilst bad debts have proven to be resilient so far, face downside skew.

Insurance stocks outperformed in 2023 as they benefit from rising rates via their investment earnings, and the rates cycle accompanied a hardening premium cycle. We see them as well placed in 2024 to grow dividends.

Overly optimistic China growth expectations

2023 saw disappointing Chinese growth. Chinese government advisers have recommended 2024 growth targets to range from 4.5%-5.5% but reaching such targets will require Beijing to step up fiscal and monetary policy to stimulate aggregate demand beyond what has been announced and overcoming significant current housing headwinds.

Compared to weak growth, surprisingly high steel production has continued to feed into optimistic expectations for iron ore, whereas prices of the broader commodity complex are acting more consistently with recession expectations.

Lithium supply and demand out of kilter

The lithium outlook has deteriorated, with supply now ahead of demand, particularly as electric vehicle (EV) take-up has fallen short. EV penetration rates have flat lined, particularly in China, but also Europe and the US. Reports out of China suggest Chinese lithium producers are not seeing production cuts and new mines continue to ramp up/expand. This could see the market oversupplied in 2024, creating extra pressure to see reduced supply growth, otherwise excess supply gets worse in 2025 with downstream industry destocking broadly playing out. As a result, we have lowered our outlook for an improved supply/demand balance and underlying spodumene prices and related Australian equities.

Travel recovery

Travel stocks have continued to see improving earnings expectations as the travel recovery has played out. International holiday travel continues to grow, with an average 95% vs pre-Covid levels over the last three months. This means the recovery tailwind has broadly passed but we still see some opportunity from here in further margin normalisation.

Valuation advantage for Australian equities

Compared to the rest of the world, our view is that consensus EPS forecasts for Australian stocks have already digested more of the economic slowing, while global (especially US) EPS forecasts remain at cycle highs. Given the economic outlook of slowing inflation and growth and the prospect of rate cuts, we expect EPS to be under pressure everywhere in 2024. At the same time, the forward Price-to-Earnings (P/E) ratio for Australia is much lower than that for global markets. Therefore, we see better value in the more discounted Australian market. There appears to be a contradiction between the economic growth pessimism of falling bond yields and the optimism of rising equity market P/E ratios.

Summary

As the world continues to normalise to peak rates and long-term inflation expectations, the environment plays towards Australian stocks with defensive earnings, robust cash flows, strong balance sheets and cost control amid the ongoing contraction in household budgets.

Right now, it is more important than ever for investors to be discerning in their stock picking, focussing on the right companies in this environment, avoiding stocks with valuation risk, or issues with poor pricing power, falling volumes, rising costs or sustainability concerns.

Growth-style stocks remain expensive, while Value stocks are still cheap relative to history. As the large spread between Value and Growth unwinds, and the market refocuses on valuations based on true earnings and dividend fundamentals, the conditions for MCA’s strategies to outperform their total return and/or income objectives remain convincing.

Value-style stocks offer attractive opportunities

Within the attractively valued Australian market, we continue to see a wide dispersion between Growth-and Value-style stocks. This valuation dispersion narrowed in 2021-2022 on higher rates, but since the peak rate narrative and excitement around AI kicked off in March 2023, the valuation dispersion has again widened.

Our view is that the greater the valuation dispersion between typical value stocks and growth stocks, the greater the excess return opportunity for a disciplined valuation investment approach.

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