Seek shelter in defensives amid falling growth and financial conditions

Bruce Apted reviews the main concerns and key market themes for Australian equities that investors should look out for over the year ahead.
Bruce Apted

State Street Global Advisors

Key market themes for Australian equities in 2023

  1. Falling growth as financial conditions tighten. Domestically, the main concern over 2023 will be the fallout from tightening financial conditions which is yet to be fully reflected across household activity due to 1) higher savings buffers and 2) the benefit of low fixed rate mortgages (housing is a key tightening channel: ~2/3 of outstanding fixed rate mortgages will expire by the end of 2023. Both tailwinds will begin to erode over 2023.1 which suggests further pullback in household discretionary spending. While headline inflation is expected to ease following the decline in oil prices, concerns around wage growth remains. With the unemployment rate back to 50yr lows, wage growth pressures remain significant. However, forward demand indicators have mostly levelled off and we expect more meaningful weakness to emerge from 1Q23 as broader activity slows and labor supply is boosted by an uplift in net migration.
  2. Equity valuations have de-rated in 2022 (FY1 PE from 24x to 14.3x) and are near long-run averages (14.7x since 1992), but earnings still at peak levels as shown below:

Figure 1: S&P/ASX 300 Index – Earnings, Returns and Valuations

Source: Factset, as of 31 December 2022. Past performance is not a reliable indicator of future performance. Index returns reflect capital gains and losses, income, and the reinvestment of dividends. Index returns are unmanaged and do not reflect the deduction of any fees or expenses. EPS = Earnings Per Share. NTM = Next Twelve Months. STM = Second Twelve Months.

From a real-earnings perspective overall market valuations can still be considered rich due to the impact of high margins which is vulnerable to rising costs, especially labour expense. Consensus profit margin forecasts by and large have remained static and in many cases above pre-Covid norms. Based on falling Financial Conditions Indices, we can expect to see material declines in earnings as growth and profits are hit by the lagged effect of an aggressive tightening cycle.

Figure 2: Tightening financial conditions lead falling earnings growth

Source: Credit Suisse Equity Research. Past performance is not a reliable indicator of future performance. Index returns reflect capital gains and losses, income, and the reinvestment of dividends. Index returns are unmanaged and do not reflect the deduction of any fees or expenses.

Stay true to your objective of managing volatility and downside risk

While some may say that a benchmark-relative approach is the best way to select and assess active equity managers, we believe investor objectives, not benchmarks, belong at the centre of portfolio construction. We define true success as not only producing “alpha”, but also managing total portfolio risk and we believe that managing volatility and reducing the impact of market losses will be key in 2023.

Investors who are invested in a benchmark-like Australian equity strategy should ask themselves – what is the key objective of my strategy? Is it aligned with getting exposure to the high cyclicality that is embedded in the Australian equity market?

How we approach concentration risks in banks and miners

As we enter 2023, the combination of higher rates and inflation is just beginning to impact consumers and borrowers, and we are likely to see further deterioration in discretionary expenditure during the year. This is likely to have flow-through effects on credit growth and the potential asset quality of banks.

Being benchmark agnostic means that our approach explicitly ignores large index concentrations, and aims to hold more stable, higher quality and less cyclical companies in a way that minimizes overall portfolio volatility and drawdown risk.

While valuations for the big 4 banks remain undemanding and our model’s overall assessment of them varies between neutral to positive (NAB has the highest expected returns), that does not mean we hold the big 4 banks at anywhere near benchmark weights. Rather, our explicit focus on volatility management translates into a portfolio that is highly diversified across different stocks and sectors, with an emphasis placed on defensive names.

The same approach is applied to our holdings of Australian miners. BHP, for example, is an attractive stock from a fundamental perspective – with a strong balance sheet and a healthy portfolio mix of commodities. However, its cyclical nature is reflected in its higher earnings and price volatility means that BHP has a beta of 1.4. This cyclicality translates to a lower absolute weight in our defensive portfolio. While the Fund has some cyclical exposures, these are measured and are selective to those companies that help the overall portfolio generate the best risk-adjusted returns.

Our preferred defensive sectors are currently:

  1. Communication Services
  2. Food and Staples, and
  3. Health Care. 

The relatively higher weights allocated to these sectors reflect our conviction that these high-quality stocks will be able to produce higher earnings and share price resilience in an environment of lower growth and tight monetary policy.

1 APRA, RBA, Macquarie Macro Strategy as of December 2022.

Learn more about risk-aware investing

For more details on how State Street Australian Equity Fund can play a part in your asset allocation, click the contact button below, or visit our website for more information.

Issued by State Street Global Advisors, Australia, Limited (AFSL Number 238276, ABN 42 003 914 225) (“SSGA Australia”). Registered office: Level 14, 420 George Street, Sydney, NSW 2000, Australia · Telephone: +612 9240-7600 · Web: The views expressed in this material are the views of Bruce Apted, Head of Portfolio Management – Australia, Active Quantitative Equity Team through the period ended 31 December 2022 and are subject to change based on market and other conditions. The information provided does not constitute investment advice and it should not be relied on as such. All information is from SSGA unless otherwise noted and has been obtained from sources believed to be reliable, but its accuracy is not guaranteed. There is no representation or warranty as to the current accuracy, reliability or completeness of, nor liability for, decisions based on such information and it should not be relied on as such. Investing involves risk including the risk of loss of principal. Investing in commodities entail significant risk and is not appropriate for all investors. Commodities investing entail significant risk as commodity prices can be extremely volatile due to wide range of factors. A few such factors include overall market movements, real or perceived inflationary trends, commodity index volatility, international, economic and political changes, change in interest and currency exchange rates. Equity securities may fluctuate in value and can decline significantly in response to the activities of individual companies and general market and economic conditions. Investing in foreign domiciled securities may involve risk of capital loss from unfavorable fluctuation in currency values, withholding taxes, from differences in generally accepted accounting principles or from economic or political instability in other nations. Because of their narrow focus, sector investing tends to be more volatile than investments that diversify across many sectors and companies. References to specific company stocks should not be construed as recommendations or investment advice. The statements and opinions are subject to change at any time, based on market and other conditions. Standard & Poor’s and S&P are registered trademarks of Standard & Poor’s Financial Services LLC (“S&P”) and Dow Jones is a registered trademark of Dow Jones Trademark Holdings LLC (“Dow Jones”) and have been licensed for use by S&P Dow Jones Indices LLC and sublicensed by SSGA. The S&P indices are a product of S&P Dow Jones Indices LLC and have been licensed by SSGA. State Street Australian Equity Fund is not sponsored, endorsed, sold or promoted by S&P Dow Jones Indices LLC, Dow Jones, S&P, their respective affiliates, and none of S&P Dow Jones Indices LLC, Dow Jones, S&P, nor their respective affiliates make any representation regarding the advisability of investing in such product(s). This document may contain certain statements deemed to be forward-looking statements. All statements, other than historical facts, contained within this document that address activities, events or developments that SSGA expects, believes or anticipates will or may occur in the future are forward-looking statements. These statements are based on certain assumptions and analyses made by SSGA in light of its experience and perception of historical trends, current conditions, expected future developments and other factors it believes are appropriate in the circumstances, many of which are detailed herein. Such statements are subject to a number of assumptions, risks, uncertainties, many of which are beyond SSGA’s control. Please note that any such statements are not guarantees of any future performance and that actual results or developments may differ materially from those projected in the forward-looking statements. This material is general information only and does not take into account your individual objectives, financial situation or needs and you should consider whether it is appropriate for you. The whole or any part of this work may not be reproduced, copied or transmitted or any of its contents disclosed to third parties without SSGA Australia’s express written consent. © 2023 State Street Corporation. All Rights Reserved. Tracking: 5437630.2.1.ANZ.RTL Expiry Date: 31/01/2024

Bruce Apted
Head of Portfolio Management – Australia, Active Quantitative Equity
State Street Global Advisors

Bruce is Head of Active Quantitative Equity - Australia, for State Street Global Advisors. He has over 20 years' experience, covering Australian and global equites, long and short equities as well as global macro strategies.

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