Expanding Opportunities

We remain relatively upbeat on the outlook for equity markets. Sturdy economic footing, falling inflation and fiscal support for thematics such as artificial intelligence (AI) and decarbonisation should continue to provide tailwinds for corporate earnings.

US equity markets have been clear outperformers in recent years, thanks to technological behemoths such as Apple, Alphabet, Microsoft and Meta. This has accelerated in recent quarters thanks to the contributions of Nvidia and the mania associated with the adoption of AI. Importantly though, returns have been driven by earnings upgrades, rather than just expanding valuations. In fact, over the last 10 years US companies have grown underlying earnings by 2x more than European companies, and more than 5x more than Australian companies.

US Earnings Dominance

Growth in underlying earnings per share (EPS), 10-years

Global Equities: Composition of Returns

Source of total return (EPS & PE ratio change), last 12-months

US continues to lead the way

It’s difficult to see this trend reversing in the near-term. The US’ sector composition, the health of corporate and household balance sheets, and the expansionary fiscal policy backdrop (irrespective of the upcoming election result) should all be supporting factors for equity returns. Instead though, we would expect to see a broadening out of performance, with industries that have been in earnings recessions (such as healthcare, industrials and materials) playing catch-up. Small and mid-cap companies also looked well-placed with attractive valuation levels and solid earnings growth prospects. The threat of ‘higher for longer’ interest rates will put pressure on balance sheets and unprofitable business models, so we think it is imperative that investors adopt a quality bias when allocating to the space.

Mega & Small-Caps Valuations: Ratio

Ratio of S&P 100 and S&P 600 P/E

An abundance of opportunity

An upturn in the global economy should also support this. It now looks like European growth has troughed and monetary policy is becoming more supportive. The Chinese economy also looks to be at a turning point with consumer confidence and consumption measures bouncing off depressed levels. Other emerging market countries such as India, Mexico and Indonesia are also benefitting from US-China decoupling and the diversification of global supply chains. This is creating an abundance of opportunities for skilled investors.

Domestic caution

The domestic stock market continues to lag behind its developed market peers, a pattern we expect to persist over the medium-term. The S&P/ASX 200 is currently trading on a forward P/E ratio of 16.5x which is about 13% higher than its long-term average. This may look reasonable in a global context (particularly compared to the US), however we remain unenthused when considering the market’s benign earnings outlook (2% compound annual growth over the next 3 years). This is largely due to our market’s ‘mature’ business profile, whereby many of the largest companies in the index are operating in established sectors or industries where organic growth opportunities are becoming harder and harder to come by.

S&P/ASX 200 Valuation P/E ratio (ntm) of S&P/ASX 200 Index

ASX 200 Earnings Growth

Year-on-year EPS growth per FY, current consensus forecast

The major banks (which account for 23% of the index) are a good example of this. Australian system credit growth is expected to average ~2.5% for the next few years, meaning the only avenue for banks to grow earnings beyond this is to aggressively cut costs. At the same time, the sector is trading at an eye-watering multiple with Commonwealth Bank of Australia (CBA) trading on a forward P/E ratio of 22x. By comparison, Alphabet (the parent company of Google) which is expected to growth earnings by 12% per annum over the next 3 years, trades on a P/E of 20x.

S&P/ASX 200 Banks: Price-to-Earnings

P/E Ratio (ntm)