SG Hiscock & Company portfolio manager Hamish Tadgell said over the last year that there has been a decoupling of activity indicators and financial conditions.
“The market has been incredibly resilient in the face of monetary tightening. Higher rates have been subverted by COVID savings, higher rates for savers and tight labour markets,” he said.
“In the last few months, market sentiment has also improved sharply on the AI euphoria and hope of a soft landing.”
Mr Tadgell said he expected headline inflation to decline further over the coming months. Without much of an increase in unemployment growth, this could see economic growth continue to be more resilient and supportive for equities.
“However, the issue of inflation is far from over given the persistence of services-led inflation. It also needs to be recognised that wage increases tend to be stickier than prices, and falling price inflation could boost real wage growth, boosting consumption and causing inflation to be persistent,” Mr Tadgell said.
“This raises the risk central banks will have to do more in taming inflation and means inflation and rates are likely to remain front and centre for markets for some time yet.”
The impact of higher rates is going to be unevenly felt across the economy and also at a sector level, Mr Tadgell noted. Financial conditions are also tightening and it will feel like a recession in some parts of the economy even if the broader economy doesn’t officially enter a recession.
“We are seeing stress in the housing and discretionary consumer-facing sectors which we expect to broaden out and carry downside risk to earnings,” he said.
“This all points to a relatively uncertain outlook and a need to be active and more selective in navigating markets.
“At a more fundamental stock level, there is risk of overestimating recent revenue growth trends for many companies. Inflation has seen an increase in most company’s top line as they’ve increased prices.
“As inflation falls, it will become harder to push through prices. This will see a slowdown in sales and margins unless costs are pulled or there’s productivity gains.”
Amid a more cautious environment, Mr Tadgell said it was natural for equity investors to assume a flight to safety, including to more liquid, larger cap companies. However, he said this doesn’t necessarily mean blue chip companies will be the beneficiaries of a shift in attitudes.
“It’s too simplistic to say blue chips will benefit from the uncertainty. It’s about focusing on the fundamental drivers and value. Which companies have pricing power, secular tailwinds and competitive advantage and position to navigate this environment?” Mr Tadgell noted.
“Balance sheet strength is the other thing that’s critical in tougher times and when rates are increasing as they are, it becomes even more pronounced.”
Despite the uncertain economic outlook, the market conditions positively favour the insurance sector including companies like QBE Insurance, Insurance Australia Group, and AUB Group, according to Mr Tadgell. Other sectors like energy and technology will also continue to do well as these are driven by secular changes.
“Secular changes like the energy transition and shift to renewables, backed by large government fiscal initiatives like the US Inflation Reduction Act, are providing opportunities for future-facing commodity suppliers and service providers like Pilbara Minerals and Worley,” he explained.
“The technology evolution including the cloud, big data processing, and AI also provides great opportunities for data centre providers like NEXTDC and Infratil as well as those companies that can harness the productivity and service benefits of this innovation.”
