Australian equities are currently trading at 8 per cent above fair value, compared to a 4 per cent premium in the US, according to Morningstar’s analysis.
Lochlan Halloway, Morningstar market strategist, noted that while Australian equities appear “more expensive than usual” and rank among the priciest in Morningstar’s global coverage, the current premium “is not extreme by historical standards”.
“That 8 per cent premium is not really that unusual,” he told InvestorDaily, noting that valuations at these levels have occurred roughly 40 per cent of the time over the past decade.
“These are not really overvalued levels, moderately overvalued is probably how we would call it compared to our global coverage list,” he said.
Halloway noted that the moderate overvaluation of the Australian market is largely driven by large-cap stocks, with the ASX 20 trading at a market-cap weighted premium of nearly 20 per cent. This concentration in large capitalisations is one of the key reasons for the local market being slightly overvalued.
“When valuations are rich at that end, that brings valuations for the whole market up,” he said.
Halloway explained that the growth of the Australian market has largely mirrored the momentum seen in the US market, particularly following Donald Trump’s re-election.
“Our market ran up alongside those big US-centric themes,” he said, adding that the growing reliance on passive investing in Australia, which disregards valuation sensitivity, has been another contributing factor.
“We have a lot of value-agnostic money that could also cause very large stocks to be pushed further and further from fair value,” Halloway said.
He highlighted attractive opportunities in smaller-cap stocks and the energy sector, noting they present value further down the market size spectrum.
“The sectors, like energy, also look undervalued, but our banks and some of our consumer cyclical stocks are trading on relatively high valuations in our view, and that’s pulling valuations across the market up,” he added.
Halloway noted that while the short-term direction of the market remains uncertain, long-term trends will likely be guided by fundamental factors.
Casey McLean, Fidelity portfolio manager, told InvestorDaily that the rotation into banks hasn’t been supported by earnings growth over the last two years.
Instead, he suggested the rally has been largely driven by flows from big superannuation funds.
“The super industry now owns 30 per cent of the banks and they’ve really been decreasing their underweight to the banks in an effort to hug the index … because they are very worried about underperforming the benchmark,” he said.
“I think there is a potential that we will see rotation out of the banks given that at these levels, valuations and fundamentals are disconnected.”
Potential for sector rotation
McLean suggested that a shift away from banks might be approaching, citing historical trends where top-performing sectors often lag in subsequent years.
Factors like sentiment towards China – potentially influencing Australian growth positively or negatively – and the Trump administration’s planned tariffs may drive a rotation from banking stocks to more cyclical areas of the market, including resources, he emphasised.
In particular, McLean noted, investors should monitor any stimulus announcements out of China or broader financial news, as these factors could impact market dynamics.
Other factors leading to a potential rotation out of banks could include anticipated interest rate cuts in Australia, which is “an obvious headwind for the banks’ earnings”.
Separately, he believes the upcoming Australian election could serve as another “potentially big swing factor”.
“If you look over the last one to two years, all of the growth in the Australian economy has been driven by government spending and migration and the private sector has actually been a detractor,” McLean said.
“If you get a scenario where there is a hung Parliament, a minority government in power, that wouldn’t be able to spend in the same way as they have been able to over the past few years, that could put a handbrake on domestic growth, which would be negative for banks as well.”
Lastly, the weakening Australian dollar could act as a tailwind for the resources sector, he concluded.
