Australian shares – which way will the pendulum swing?

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The outlook for Australian equities over the coming year is mixed. While there are reasons to think Australian shares may perform well, there are also several important risks for investors to consider.

As many investors no doubt already know, Australian equities have been on the back foot so far this year. This largely reflects aggressive central bank tightening around the world to contain a post-COVID surge in consumer spending and inflation. Higher interest rates have pushed down equity valuations – and hence equity prices – even while corporate earnings have to date remained fairly resilient.

The bright side

On the bright side, equity market weakness to date has improved equity valuations. At the time of writing, Australia’s S&P/ASX 200 Index was trading at an undemanding 13 times forward earnings – modestly below its long-run average of around 15.

What’s more, there’s a reasonable chance that local and global inflation could soon surprise on the downside like it surprised on the upside over the past year. Global supply chain bottlenecks are easing, as is the initial surge in demand for goods and services following the removal of COVID restrictions, which should help to cool inflation. Long-term inflation expectations remain fairly contained in most countries, and heightened global competition should lessen the risk of a 1970s wage-price spiral.

As and when inflation eases, central banks may halt raising interest rates and could even loosen monetary policy in 2023 to support economic growth. That would mean earnings won’t need to fall all that much and equities could recover due to a lift in beaten-down valuations.

Other factors could also support Australian shares – at least relative to those overseas. Wage inflation remains lower here than in the US, meaning the RBA has less need to slow the economy and increase unemployment to keep inflation in check. And as horrible as the war in Ukraine has been from a humanitarian viewpoint, the ongoing conflict could help keep global energy and food prices relatively high, which is supportive for commodity-producing countries such as Australia.

The not-so-bright side

That said, the outlook is not without risk. One challenge is that inflation globally has remained stubbornly high so far this year, in large part because economic growth has also so far remained fairly resilient to central bank interest rate increases. In turn, this reflects a build-up of high household savings and pent-up consumer demand from the COVID crisis.

In order to sustainably bring down inflation, central banks may face no choice but to keep raising interest rates until there is a clearer slowdown in economic growth – which is usually not great news for equity markets.

Apart from interest rates and inflation, there’s also the risk of an escalation in the Russia-Ukraine war. And although it might keep commodity prices high, any escalation in the conflict risks unnerving global business sentiment and most likely sending at least the European economy into recession.

An ongoing weak Chinese economy also remains a risk. China’s COVID-zero policy continues to cause intermittent disruptions to economic growth, while its property sector is also dealing with debt-fueled overhang of construction.

Climate change is become increasingly evident and problematic – with persistent droughts in some parts of the world and persistent flooding in others.

Conclusion

All up, while there are some grounds to believe Australian equities could do well over the coming year, it still really depends on global economic growth and the path of interest rates and commodity prices.

Ultimately, I’m not that confident that global inflation will fall fast enough of its own accord – meaning central banks may conclude a hard economic landing is required to bring it down before it’s had a chance to feed into high inflation expectations among wage and price setters. We likely still face a challenging few months ahead.

Either way, investors would do well to remember that it is always darkest before the dawn. History shows it’s precisely when stocks are in the doldrums and few can see anything positive ahead that markets are often prone to turning the corner. Even if it takes a while, one way or another, global inflation should fall back towards more normal levels over the coming year, which could set up equities once again for an economic upswing and new bull market.

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Written by

David Bassanese

Chief Economist

David is responsible for developing economic insights and portfolio construction strategies for adviser and retail clients. He was previously an economic columnist for The Australian Financial Review and spent several years as a senior economist and interest rate strategist at Bankers Trust and Macquarie Bank. David also held roles at the Commonwealth Treasury and Organisation for Economic Co-operation and Development (OECD) in Paris, France.

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