Three Outcomes That Could Drive a Reacceleration in Growth

The RBA left rates on pause this month. But they will cut soon. Those rate cuts will help the economy achieve the softest of all landings. And that is why Australian equity valuations look fine.

So goes the narrative. But the underlying data are increasingly worrying. Equity fundamentals are not just weak. They have snapped lower. Investors will need to reckon with further economic weakness before the RBA cuts. And that has increased the risk we see a meaningful correction in Australian equity prices.

Fundamentals are weak.

The recent reporting season in Australia was reasonable, compared with low expectations for earnings outcomes. But that doesn’t hide the fact that sales growth is slowing, margins are contracting and earnings growth is weak. That is very much at odds with the multiple expansion we’ve seen at the index level.

But equity markets are forward looking.

So what can we infer from the disconnect between actual earnings growth and the elevated index? To justify the valuations, the market will need to see an inflection in earnings growth. And not just an inflection, but a material reacceleration in growth.

Three ways that growth can reaccelerate.

We’ve spoken with a number of Australian equity managers to gauge what could drive that reacceleration.

1. Population growth. A surge in migration has pushed Australia’s population towards 27 million. Population growth is a key driver of economic growth. At an aggregate level, more people will spend more than fewer people, all else being equal. And that has been evident this year. But I do not expect population growth to continue – and at a micro level households are cutting back on spending as high debt levels and interest payments bite into disposable income.
2. Rate cuts. Interest payments have increased as the RBA hiked rates through 2023. But markets have now moved to price rate cuts. And if the RBA cuts sufficiently aggressively and soon, then the economy could reaccelerate. But monetary policy acts with a lag, and I expect the rate hikes to date will continue to work through the economy. And the RBA is probably further away from cutting than the market is pricing. The risk of disappointment is high.
3. Commodity prices increasing. The collapse in the iron ore price has impacted revenues for a significant part of the Australian share market. Several managers have pointed to a potential rebound in commodity prices that could help reaccelerate earnings growth. But global growth is slowing. China’s demand is stabilising but is unlikely to resurge. We don’t forecast ore prices, but I am sceptical of this being a meaningful driver of earnings growth in the near-term.

Prices and fundamentals are dislocated.

We have a situation where the market is pricing a growth reacceleration, economists expect a soft landing, and actual data are pointing to slowing growth. This dislocation is a reason to reduce exposure to Australian equities.

A recession is not needed for an equity repricing.

Instead, if the Australian economy continues slowing rather than reaccelerating, then we are likely to see a correction back towards fair value. There are a number of catalysts that could force the market to rerate soon – weaker economic data or stickier inflation among others. Given the extent of the dislocation, the correction could be sudden and violent. Reducing Australian equity risk now after a strong rally makes sense in diversified portfolios.

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