Two ASX sectors presenting opportunity in an earnings downgrade cycle

There's a need to be more selective within the Australian equities space, says Katie Hudson of Yarra Capital Management.
Katie Hudson

Yarra Capital Management

As we head into 2023, the one thing equity investors need to be watching is the depth of this earnings downgrade cycle. There's no doubt earnings in some sectors will be coming off the boil thanks to high inflation, rising interest rates, and shrinking consumer demand. The current consensus for earnings declines is around 3-5%, but we believe there is more coming

Having said this, we see no reason for the Australian economy to experience a severe downturn - let alone the most forecast one in living memory. Nor do we see a reason why investors should be waiting for the bottom of the earnings downgrade cycle before starting to buy equities.

In this video, I'll share with you my latest insights on the equity market. These insights include two new sectors where we're seeing lots of investor potential in 2023. I'll also share with you two sectors that we are avoiding at present given the potential for an economic downturn.

You can watch the video below or read an edited transcript.


Review of 2022 (00:11)

2022 was characterized by a year of volatility. Although the large cap part of the market, the ASX 300 ended, the year down 1%, at one point during the year it was actually down north of 15% from its high. And there was a lot of dispersion within that: the energy sector up over 40%, the technology sector down over 30%, and a number of industrials down quite significantly as well.

In contrast to that, the small cap part of the market actually ended the year down 19% with only the energy sector up, over 40%. The rest of the market was actually down and a number of industrial stocks were down over 30 or 40%.

So, that's quite significant volatility. The key lesson for us is in periods of very volatile markets where you have multiple turning points, it's really important to stay focused on that investment horizon. For us, that's three or four years, and within that you tend to find a lot of opportunities.

What matters most right now? (01:10)

The key thing investors are focused on is the earnings downgrade cycle, against a backdrop of a rapid rise in interest rates on the back of high inflation. There's an expectation that demand will be impacted, margins will be impacted, and earnings will continue to be downgraded. And that'll absolutely be something we're focused on through the February reporting season.

In my career, I don't remember a more anticipated economic downturn, and certainly one with such a long lead time. So it does beg the question why investors haven't got the earnings expectations right? Certainly it's a key reason why you don't want to wait until the bottom of the earnings downgrade cycle to buy equities because markets do anticipate it.

That's certainly what we're seeing at the moment. What we've seen so far, depending on the sector, is earnings downgraded by about 3-5%. But we think there's more to come from here.

How is Yarra positioning its portfolios? (02:03)

With the large cap part of the market having traded largely in line with where it started the year last year, driven predominantly by banks energy and some parts of the resources market like lithium, we're seeing less obvious opportunities in that part of the market.

Where we are seeing a number of opportunities is in the small cap part of the market, particularly in a number of the growth names that sold off hard last year. That's areas like technology and some of the financials, we're seeing some really interesting opportunities there. They're the parts of the market that we are focused on.

A number of the cyclical areas we think still have downgrade risks, so we're stepping carefully into those, but there will be opportunities emerging as that downgrades cycle continues. And certainly for some sectors that had a really strong demand environment during COVID, like retail or housing, we're steering clear of those at the moment because there's still an earnings normalization that needs to occur.

Outlook for 2023 (03:00)

Post the recent rally that's gone through December and has continued into January, we think there's a need to be more selective within Australian equities.

What we are really focused on is what's happening with the Australian economy, because that tends to be a really important driver of what happens with Australian equities. And when we think about the Australian economy, we think there's a number of reasons to be optimistic in a relative sense. We're certainly not forecasting the Australian economy to be super strong in an absolute sense, but relative to the UK, US and Europe, there are a number of reasons to be optimistic.

In particular, migration is rebounding in a very material way, nominal income growth is strong, savings buffers are good, and the deficit looks likely to move into a surplus. Over 80% of our exports are extremely strong - commodity prices are staying elevated - and of course on a medium to longer term view, you've got Australia really well positioned for that transition to decarbonization. That's both through LNG, which is an important fuel through the transition, and of course lithium and copper which are both important longer term commodities. Australia is extremely well positioned for those as well.

So as we think about the relative opportunity, the Australian economy looks to be positioned well, and that should be supportive for Australian equities as well.

Discover small and mid cap potential

Australian investors can access the Yarra Australian Smaller Companies Strategy via the UBS Yarra Australian Small Companies Fund, a fund which has been managed by Yarra Capital Management since December 2018. To be notified of my latest insights, hit the follow button below. 

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Katie Hudson
Portfolio Manager
Yarra Capital Management

Katie is a portfolio manager focused on the small and midcap universe and, in addition, serves as the Firm's Head of Australian Equities Research. Katie has more than 20 years of experience in investment markets, including roles as an equities...

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