Upside drivers for Australian equities

Funds Management

by Clive Tompkins

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Jun Bei Liu, Portfolio Manager of Tribeca's Alpha Plus Fund, discusses factors behind the equity bull market, and also downside risks.

Hi. Australian equities have risen around 60 per cent since their March 20 COVID lows. This puts them back in line with their February 20 high, but performance-wise, they have substantially lagged global equities. It will not be surprising for the market to rise another 8 to 10 per cent by year end, supported by rising dividends, stronger earnings and minor valuation expansion in some areas.

The equity bull market remains intact and we are now in a phase for equity markets where the price gain will slow somewhat, the easy valuation reset has occurred and volatility will pick up because the bond yields are now rising, but performance should broaden out into many sectors. In a way, it's a more widespread economic upturn. Cyclical areas of the equity market should remain well supported, either domestically or internationally. And some of the sectors, such as Energy and Commodities, will be well supported.

There are four key upside drivers for the Australian equity market: economic improvement, expansionary fiscal and easy monetary policy, improving corporate earnings and rising dividend yield. Now, first on economic improvement, further economic improvement, off the back of the domestic economy reopening and the global recovery remaining on track, supported by US and China. Now, we are seeing some COVID outbreaks in regions such as India we don't believe at this point will disrupt the global reflation trade.

Now, expansionary fiscal policy was clearly evident in the more recent federal budget, which has shown very strong commitment by the government to put short-term goals ahead of longer term debt-burden commitment. Now, the government's commitment was very clearly being pointed towards supporting the economy at all costs, which is the right thing to do to help the economy to come out of COVID-related impacts.

The easy monetary policy condition will remain in Australia with very low interest rates. A lack of inflationary pressure will keep the RBA sidelined until spare capacity is removed from the labour market and upside price pressures are becoming sustainable.

Improving corporate earnings -- driven by rebounds in cyclical and financial sectors, ongoing strength from the resources sector, which is in a bull market for commodities, and in laggard sectors benefiting from government supports, the sectors such as tourism and hospitality. There remains substantial upside for Australia to regain pre-COVID-19 levels of earnings across so many sectors. Now, a normalisation in dividend payment will be a very strong factor for outperformance of the Australian equity market, as many, many businesses are earning to recover faster than expected and with strong cost of CapEx control to allow very strong cash flows.

Now, there are also some downside risks, of course, for the Australian equity market, but we don't believe any of them are sufficient enough to create major harm to the equity market outlook. Now, the first one is valuation. Now, there's been many discussions about valuation being way too high for the share market, but we don't believe so, and we don't believe valuation is a market-wide concern. While elevated, they're not a headwind for the entire market, unless the interest rate rises substantially, and we don't expect this to occur. Consequently, there are pockets of overvalued stocks, predominantly in the growth stocks and those that are COVID-19 winners. But, broadly speaking, the Australian equity market does not have a valuation problem. This is why rising inflation and rate fear are disproportionately impacting high-multiple companies and not cyclical and value stocks, which trade much, much more cheaply.

Now, fear of inflation is another issue that's been discussed quite a lot. It is certainly emerging for the market, and it has driven a bit of profit taking and some of the market weaknesses. However, we think it's way too early to determine if the inflation will be sustained and/or how high it will rise. We believe that inflation is highlighting a pressure point for the equity market, which has overextended valuation in some areas. We think, as positioning and valuations normalise in those growth stocks and COVID-19 winners, then the market will continue its upward trajectory.

One other risk causing a bit of a concern is the COVID-19 outbreaks in many regions and also vaccination delays. They certainly will impact sentiment, but we believe are unlikely to derail the recovery as economies continue to reopen and as policy support remains in place. Australia may face ongoing vaccination delays and outbreaks, but it has now progressed far enough to see limited damage to the economy and markets. Similarly, the US is approaching herd immunity, and other economies will follow.

So, in summary, the speed and size of the equity market rally is causing some concern by investors, as are fears of inflation and rising rates. But high interest rates are coming with stronger growth, and this will be a strong offset for the equity market. The two biggest drivers of the equity market are valuations and earnings, and both remain supportive for further upside as we look out towards 2022. Lastly, even if economic recovery or momentum slows, as we expect, equity will continue to outperform bonds, as long as the economy is in expansionary territory. And the leading indicators are suggesting this certainly is unlikely to change for quite some time to come. Every investor should understand that if the broader economy and corporate earnings are recovering as they continue to do so, then the overall equity market will generally move higher. It might get rocky from here, but the underlying trend is up, not down.

Thank you.


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