Why Australian mid-caps are set to shine

If the past 12 months has taught investors anything, it’s that being selective and diversified is key to riding the economic cycle. Had investors avoided risk assets on the back of many economists calling the “most anticipated recession” that never happened, they would have missed the double-digit return recorded by the S&P/ASX 200.

More recently, we’ve seen the market shift its expectations for a soft landing and an increasing likelihood for policy rate cuts. It’s allowed the Big Four banks to surge to all-time highs, and unprofitable tech names come back to the fore.

But what does this all mean going forward?

In short, inflation is likely to remain sticky and those rate cuts aren’t coming as quickly as you hope. A soft landing is the expected scenario, but don’t expect much relief in household budgets.

I’ll share a summary of our newly released Australian Equities Outlook and why we believe the environment is looking favourable for Australian mid-caps.

A soft-landing with some caveats

Inflation has eased off but expect the pace of that slowdown to cool. There’s accelerating rental prices and wages growth, food inflation and pick ups in energy prices continuing to push headline inflation figures up. 

Wages inflation is a key threat. We’ve seen state governments remove public sector wage growth caps to address falling real wages growth and there’s near record low unemployment boosting private sector wages. The aggregate wages growth is above the RBA’s published target of 3.5% and isn’t supported by productivity gains. This all risks fuelling higher inflation gains.

While that’s one reason we shouldn’t expect the RBA to cut rates any time soon, another factor comes to rent inflation and migration.

Rental inflation is the largest contributor to services inflation and is the highest level since 2009. It’s hardly a secret as to why, with rental vacancy at an all-time low and Australia experiencing a surge in migration.

The RBA has a mandate of achieving “price stability and full employment”. This increases the chance of a soft landing. 

The bank has noted that their primary objective is to avoid a recession at the expense of a longer period of elevated inflation. RBA’s latest forecast has inflation returning to the 2-3% target range in late 2025.

Geopolitical tensions are one of the key risks to this forecast. For example, energy prices spiked following Russia’s invasion of Ukraine and in turn hit inflation. The latest concern is the Red Sea Crisis which has resulted in ships that would normally pass between Saudi Arabia and Egypt to instead go all the way around Africa to get to Asia. The outcome has seen shipping prices jump 3.5 times. We could see this spike pass into goods prices to consumers in the second half of 2024.

Why mid-caps are looking promising

The latest reporting season highlighted resilient consumer spending, cost management, inflation moderation and positive economic outlooks. This all translated to strong results for large caps, consumer discretionary, real estate and information technology sectors.

That said, we think mid-cap exposures are looking the most attractive in the coming months, for a few reasons:

1. Mid-cap investments reported the highest upside price target consensus revisions.
2. The environment bodes well for a mid-cap rally, supported by overweight exposure to cyclical sectors such as industrials, consumer discretionary and real estate.
3. There are attractive valuations. Forward P/Es are trading below historical averages.
4. Smaller companies traditionally offer more upside potential through market share expansion have historically outperformed when markets heat up.

Further to this, it can be a good way to reduce exposure to Australian banks. We think the market is underestimating the impact of future mortgage stress and the banks are looking overvalued.

Other areas displaying attractive valuations include real estate, particularly office and retail REITs, industrials and consumer discretionary sectors.

Leverage levels in REITs have decreased, with interest coverage increasing since the Global Financial Crisis. When it comes to office, falls in occupancy rates have stabilised, with net operating income picking up, while retail REITs have had strong occupancy rates and accelerating net operating income.

While referencing consumer discretionary may come as a surprise, particularly as we expect household budgets to continue to be squeezed, this sector is supported by migration. Australia’s migration surge will continue to support aggregate retail spending and therefore consumer discretionary performance. That said, we expect continued low unemployment and an improving economic outlook to translate to improved consumer confidence and spending over time.

Key takeouts for investors

There’s no such thing as a crystal ball on markets, and geopolitical events could be just as likely to throw any forecasts out the door. Focus on selective investing and remaining diversified across the market.

As mentioned above, Australian mid-caps could be set to shine. Valuations are attractive and smaller companies typically outperform in a recovery. Sector-wise, A-REITs, industrials and consumer discretionary are our picks.

Get more insights from Cameron McCormack here.