Caution Warranted

The Australian economy is holding up far better than expected given higher interest rates. There has been some slowing but far less than most economists feared.

There were major concerns for the consumer given that one third of households have mortgages. However, it appears that excess savings accumulated during the COVID years has limited the damage and there have been offsets from other areas such as immigration and a wave of construction spending.

Risks remain

These risks have not completely abated. Inflation rates have fallen but there is still plenty of inflation pressure in the pipeline from electricity, rents and insurance. The labour market also remains tight and we are yet to see the full flow-through of large rises in awards, minimum wages and some public sector agreements.

Construction and capex

While the short term is uncertain, Australia is well positioned for medium term expansion. The next global cycle appears set to be dominated by major capex programs in the energy infrastructure, healthcare and manufacturing sectors. This should provide strong support for commodity demand. We are also in the early stages of a local construction wave driven by the Brisbane Olympics, a second Sydney airport, major road and rail projects and a rebuilding of the electricity network to accommodate the adoption of renewable energy.

Stretched valuations

The Australian equity market has followed the US market higher in recent months and valuations now appear stretched. Banks and blue-chip company valuations are back near record highs. The recent reporting season showed a divergence in outcomes by sector. Pricing power, cost control and a resilient economy allowed many industrial companies to beat earnings expectations. However resource companies reported cost overruns and were hurt by falls in some commodity prices.

Banks are one area where caution is warranted. They have performed well because of strong dividends and expanding margins. But margins will soon peak as deposit rates rise, the cost of other funding increases and they compete more aggressively for new business. There is also still the risk of credit deterioration as higher interest rates eat away at borrowers.

For resources, there are some short term concerns as key commodity prices remain weak. This is particularly the case for iron ore. However energy and gold prices are rising and stock prices have lagged for producers of these commodities. Energy stocks are also a good hedge against geopolitical risk.

REITs have lagged the market as investors remain concerned about asset values and the delayed impact of higher rates. These fears appear to be overdone in some parts of the market. Retail REITs in particular are trading at large discounts to underlying values even though the outlook for the sector has stabilised.

Australian Business vs Consumer Confidence

ASX 200 Valuation

Price to Earnings (PE) Ratios for Australian Major Banks