Australian equities have been resilient this calendar year amidst a challenging macro backdrop.
The ASX 200 has gained +2.2% (including dividends) this year to date, outperforming the MSCI World, which is down -14.1% in USD terms or -5.6% in AUD terms due to the FX translation benefit of a stronger USD.
The ASX 200 is overweight resources and financials compared to the rest of the world, which explains the strength of the Australian market this year.
2022 Sector Performance
While the Australian market has been resilient at the index level, there has been a high dispersion of returns between sectors and individual companies in 2022, underscoring the value of stock selection and active portfolio management in the current environment.
Resources on top
Resources have been the 2022 winners. Australian energy producers have benefited immensely from soaring coal and LNG prices for most of 2022, driven partly by the Russia/Ukraine war, which has led to significant energy supply shortages throughout Europe.
The Australian mining sector has had another solid year on the back of a generally strong backdrop for commodities despite the subdued macro backdrop in China.
The all-important iron ore sector has held up surprisingly well overall, staging a comeback in recent months, along with other China-focussed industrial commodities like Copper, in hope that China relaxes its COVID stance in 2023.
The standout mining sub-sector has undoubtedly been Electric Vehicle (EV) Minerals. The lithium carbonate price has risen +100% over the year on strong demand from the growing uptake of EVs and concerns of a looming supply deficit, benefiting the major ASX lithium players considerably.
Bond sensitives hit the hardest
Tech-oriented sectors have come under valuation pressure due to their inherent exposure to high growth and pre-profit companies with long runways for future earnings growth, but little in the way of current earnings. As a result of higher discount rates on future cash flows (via higher bond yields), these companies have de-rated considerably.
The real estate sector has struggled against the prospect of higher capitalisation rates and, therefore, lower property valuations due to the impact of higher interest rates.
Consumers expected to have a tough year
Consumer discretionary companies have come under pressure despite a relatively resilient consumer. Investors have eyed a slowdown in spending over the next year, with cost of living pressures poised to impact household budgets and erode non-essential expenditure.
Outlook for 2023: Earnings Caution, Valuation Optimism
Focus on earnings rather than valuations
The focus in 2022 has been on equity valuations rather than earnings. This has been a key driver in the de-rate of the ASX 200 since the beginning of the year.
We think there will be a shift in focus towards earnings instead of valuations over 2023, driven by 2 factors:
- Light at the end of the tunnel in the rate hike cycle (market starts to see the top), shifting the focus away from valuations.
- A global and economic slowdown (caused by aggressive central bank policy to fight inflation in 2022) will shift the focus back to company earnings. Also, a slowdown will likely lead to lower bond yields as the market gets more cautious about growth.
For our Australian equity strategy, this means a shift towards companies with predictable earnings or structural earnings growth that are less at risk of earnings downgrades in an economic slowdown.
Reduce earnings risk
To reduce earnings risk, we have trimmed our exposure to cyclicals over the past quarter. We moved to underweight the banks and trimmed some of our cyclical value stocks such as Tabcorp Holdings (TAH), Seven Group Holdings (SVW) and QAN (Qantas Airways). We have a barbell tilt towards defensives and structural growth with an overlay of quality.
Defensives perform well in slowdown periods, as these earnings are generally insensitive to the economy. We have a preference for Cleanaway Waste Management (CWY), Lottery
Corporation (TLC), Insurance Australia Group (IAG), and Telstra Group (TLS) for defensive exposure.
Structural growth stocks should benefit from less valuation pressure but can also grow earnings at whatever point in the cycle. We have a preference for Nextdc (NXT), Netwealth Group (NWL), Aristocrat Leisure (ALL), Seek (SEK) and Xero (XRO) for growth exposure.
Quality tends to shine through in slowdown periods. Stocks like Macquarie Group (MQG) can use the market turmoil to take market share, acquire assets on the cheap and benefit from market volatility (trading business). We think being overweight these factors will be important in outperformance over the first half of 2023.
2023 - A Buying Opportunity For Quality Cyclicals
Over the course of CY2023, if the economy starts to soften and cyclical earnings continue to get downgraded, this may provide an astute opportunity to buy some quality cyclicals that get oversold in the process.
We still hold companies like James Hardie Industries (JHX), Macquarie (MQG) and Nine Entertainment Co Holdings (NEC) that are cyclically exposed. However, these companies come out of the other side of slowdowns or recessions in a stronger position than when they entered them. This is largely down to the superior products/services these companies offer compared to competitors and superior balance sheet management.
We want to avoid the lower-quality cyclicals that can struggle in slowdown periods.
Key Sector Overweight – Keeping Portfolios Healthy
Healthcare is still our pick of the sectors for 2023. Healthcare ticks a lot of boxes for a number of scenarios next year.
Firstly, demand is relatively inelastic for the product and services healthcare provides – this has led to outperformance in previous periods of a slowing or contracting global economy.
Secondly, as a high valuation sector, healthcare can rerate on news of falling inflation and central bank easing.
Thirdly, after a pandemic-induced downgrade cycle, we believe we are at the beginning of an upgrade cycle for the healthcare sector.
In our view, the sector should outperform the ASX 200 over the course of 2023, as investors avoid domestic earnings risks. For this reason, it is one of our biggest overweights in the Focus Portfolio at 14% compared to the market at 9.9%. Our stocks preferences are CSL (CSL), Resmed CDI (RMD) and Telix Pharmaceuticals (TLX).
Key Thematic – EV Minerals to Continue Charging
To achieve net-zero CO2 emissions in 2050, a radical transformation of the global energy system is required. This requires a big expansion in investment and a significant shift in capital spending. Annual investment in energy will increase from just over US$2t globally on average over the last 5 years to almost US$5t by 2030, according to the International Renewable Energy Agency.
We believe one of the best ways to play this thematic is through the minerals and metals that will be in high demand as we progress through this decade and beyond. The Focus Portfolio has exposure to lithium and rare earths.
Read our recent reports on the energy transition and rare earths below:
Lithium miners rallied in 2022. We think this can continue in 2023. The market has not fully quantified the volume of required commodities accurately in relation to the transition, and many battery mineral miners are still undervalued relative to potential growth of their underlying commodities. This disparity should continue to close in 2023, leading to higher long-term price forecasts (bullish for lithium miners).
China Reopening – Not Clear Cut
We don’t think a full reopening (and full easing of COVID restrictions) will happen in the first half of 2023 (at least). Unlike other countries’ reopenings (e.g. Australia) over the past 12 months, which were generally quicker than the market expected, we think a fast China reopening would be disorderly and punctuated with setbacks, so we remain cautious on the recovery narrative.
We remain cautious due to the following:
- China’s vaccines (Sinovac and Sniopharm) are potentially less effective than mRNA vaccines (available in the developed world).
- Vaccination rates of the elderly are still relatively low.
- A full, fast reopening could strain China’s healthcare system – especially in a winter flu season.
Furthermore, the reopening is more likely to be a consumer story rather than a property boom story.
Iron ore and iron ore miners have surged on news from China of support for the property sector and easing COVID restrictions. The latest changes are favourable for the property market at the margin. However, they do not provide the all-clear to upgrade the outlook for iron ore to the levels we have seen so far.
The property market ultimately needs to be boosted by an improvement in Chinese homebuyer sentiment (which is still very, very low). The real estate sector, and by extension, iron ore demand, is not yet clearly on the cusp of robust growth.
Consequently, we caution against chasing the rally and suggest taking profit on some iron ore miners as we believe the market got ahead of itself on the reopening and property sector stimulus.
Cautious but not fully discounting
While we are cautious, we do not want to fully discount China’s ability to push ahead with a reopening (whatever the consequences). We are underweight the iron ore miners but remain overweight lithium, rare earths and oil & gas, which are all leveraged to a China reopening in terms of demand for these respective commodities.
After the strong rally in iron ore miners over the past month, we think there is more upside to EV minerals and oil relative to iron ore as reopening sentiment improves further.
Improved sentiment on the reopening may still be a key driver of returns for resource stocks over the first quarter of this year, but stay cautious on the magnitude.
| Company Name | Ticker | Sector | Beta | Share Price | 12mth fwd PE | EPS Growth FY1-FY2 | ISG Comment |
| Low Earnings Risk | |||||||
| NEXTDC | NXT | Information Technology | 0.30 | 9.19 | 335.2 | 92% | NXT is a leading data centre owner that is leveraged to structural growth in cloud adoption. The business has a high degree of earnings visibility given the contracted nature of its earnings which includes embedded cost pass throughs. |
| Lottery Corporation | TLC | Consumer Discretionary | 0.31 | 4.77 | 29.6 | 8% | TLC is the leader in Australia's lotteries market with exclusive and/or long dated licences in all States and Territories excluding WA. Lottery sales are typically resilient through the economic cycle, which underpins a relatively defensive earnings profile. |
| Portfolio Health | |||||||
| CSL | CSL | Healthcare | 0.45 | 298.20 | 34.4 | 27% | CSL is the dominant player within the global blood plasma industry. The Immunoglobulin (IG) market is supply constrained, while underlying demand is highly defensive given IG is used to treat patients with a range of serious immunologic and neurologic diseases. The business is poised to benefit from the ongoing recovery in plasma collection volumes and investments into its collection infrastructure, which should drive support both top line growth and stronger margins. |
| Resmed | RMD | Healthcare | 0.19 | 32.45 | 33.4 | 7% | RMD is the dominant global provider of continuous positive air pressure (CPAP) devices for the treatment of sleep disordered breathing. The global CPAP market remains significantly under-penetrated, which drives typical organic 'system growth' of 6-8% p.a. (vs the healthcare avg at 2-3% p.a.). RMD is well positioned to grow its market share meaningfully over the medium-term if it can capitalise on a product recall from its major CPAP competitor, Philips. |
| EV Minerals | |||||||
| Allkem | AKE | Materials | 1.66 | 13.04 | 7.9 | 18% | AKE is one of the world's top 5 lithium producers with operations in brine, spodumene and hydroxide. The business has significant production growth expected in the coming years (5x by 2030). AKE is well positioned to benefit from the rapid growth in Electric Vehicle uptake and trades at a compelling valuation relative to peers. |
| Mineral Resources | MIN | Materials | 1.37 | 88.30 | 7.4 | 37% | We think MIN's lithium business (a top 5 player globally) is being materially undervalued by the market at present. MIN also has a leading mining services business providing high quality recurring earnings from tier 1 clients, and offers upside optionality to the China re-opening thematic via its iron ore business. |
| China Re-opening | |||||||
| Lynas Rare Earths | LYC | Materials | 1.10 | 8.26 | 14.1 | 53% | LYC is the #1 producer of rare earth minerals outside of China, which is poised to benefit from significant growth in demand driven by Electric Vehicle uptake and investment into renewable energy infrastructure. LYC has leverage to China re-opening story given the country dominants downstream rare earth processing, with ~90% share globally. |
Source: Refinitiv, Wilsons.
Written by
Rob Crookston, Equity Strategist
Rob is an experienced research analyst with a background in both equity strategy and macroeconomics. He has a strong knowledge of equity strategy, asset allocation, and financial and econometric modelling.
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