Martin Conlon
Strong company earnings may be masking a less sustainable economic backdrop according to Schroders’ Australian equities team.
Despite Australian companies delivering a broadly positive reporting season, investors should be cautious, says Schroders Head of Australian Equities, Martin Conlon, who believes the disconnect between equity markets and bond markets was becoming increasingly important for investors.
“Results were broadly positive, but investors need to understand why the operating environment is so supportive at the moment,” said Conlon.
“The government is spending a lot more than they collect in taxes, there’s still relatively strong credit growth in the private sector, and you’ve also got a lot of spending by the hyperscalers. All of that is building up to an inflationary environment. But it also means that lots of companies have plenty of revenue growth. Where they do have pricing power, they’re generally exercising it, which means the results are pretty good for those companies benefiting from strong pricing environments.
“The question for investors is whether those conditions are sustainable. We think they are currently better than normal, and the bond market is increasingly telling the equity market that those conditions will need to be constrained.”
AI: an inflationary force before it becomes deflationary
Artificial intelligence is emerging as a significant force across the real economy, but investors should not yet assume that promised productivity gains will automatically translate into higher earnings for traditional businesses, says Equities Analyst Jennifer Odjugo.
“Every company has an anecdote about making gains from AI. The challenge is finding those gains in the earnings, and that has been difficult to see so far,” said Odjugo.
“Block and WiseTech are two interesting examples. Both have attributed significant workforce reductions to AI, but when you look more closely at the businesses, there are also clear signs of broader right-sizing. So it is difficult to say that AI productivity gains are yet flowing through clearly to earnings.”
Instead, AI investment is creating significant demand for hardware, computing power, electricity and construction, with the potential to crowd out other areas of the economy.
“We’re already seeing that in hardware. Apple has increased prices across several of its products, while memory chips and other hardware are also experiencing significant price increases. So far, the more obvious impact of AI is inflationary rather than deflationary.”
Copper enthusiasm runs ahead of fundamentals
Schroders Head of Research, Justin Halliwell, said the market’s enthusiasm for copper has pushed valuations of major miners to levels that are difficult to justify on fundamental assumptions.
“BHP has become the largest stock in the Australian market, with its market cap increasing substantially this year as investors have embraced its copper exposure.
“The market cap of BHP has increased by around $110 billion this year, while Fortescue has gone backwards, which tells you how much investors have rewarded the copper narrative.”
However, Halliwell said investors should distinguish between the attractive long-term demand outlook for copper and the price already being reflected in copper equities.
“Copper has a positive long-term backdrop, particularly from electrification and data centres, but the price has become very elevated,” said Halliwell.
“Data centres are an important source of incremental demand, but they are still a relatively small part of a 30-million-tonne global copper market. At much higher copper prices, the other 99 per cent of demand becomes increasingly price-sensitive.”
Halliwell said the team remained cautious on copper stocks because valuations were already discounting an extremely strong long-term copper price.
“We’re not buying copper, we’re buying copper equities, so what matters is what is already being priced into those equities,” he said.
The team sees a more compelling relative opportunity in Rio Tinto, given its combination of copper, aluminium and lithium exposure, with aluminium potentially benefiting from the increasing competition for electricity created by data centres and broader electrification.
Gold equities: momentum has moved ahead of the fundamentals
The team remains cautious about the sharp rally in Australian gold equities, with Odjugo noting that gold stocks have significantly outperformed the underlying gold price.
While central-bank buying and concerns around the US dollar have supported the gold price, Odjugo said the disconnect between gold equities and the underlying commodity had become increasingly pronounced.
“Gold equities are currently riding beyond where the gold price is, and that is partly being driven by where multiples are,” she said.
“Our concern is that there is a significant amount of momentum in the sector, and the relationship between gold prices and bond yields has become dislocated.
“We think that relationship could ultimately normalise, which means investors need to be careful about making decisions based on recent gold equity performance.”
Housing and credit: the windscreen matters more than the rear-view mirror
Looking ahead, Conlon said investors should pay closer attention to credit growth than headline inflation when assessing the direction of the economy.
Housing credit growth is already slowing, while changes to negative gearing and capital gains tax are placing additional pressure on the domestic housing market.
“Credit is the input and inflation is the output. If credit growth slows sustainably, there is less money coming into the system and, ultimately, less inflationary pressure.
“What’s important for investors is what the economy looks like through the windscreen, rather than what has happened through the rear-view mirror.”
The team believes this creates a more challenging outlook for sectors that have benefited from strong credit growth, particularly the banks.
Conlon said the banking sector could face greater pressure if housing conditions deteriorate further, with bad debt charges currently providing little drag on reported profits.
“If asset prices start to fall materially, you would expect bad debts to increase and profits to come under pressure,” he said.
Private credit risks remain contained – for now
The team also addressed concerns around private credit and recent stress in the Australian property and development market, arguing that the risks to listed equities and the banking system remain relatively contained provided asset prices do not experience a significant further decline.
Halliwell said the structure of private credit meant losses should, in principle, be borne by investors who had taken the associated risk rather than being transferred to bank depositors or taxpayers.
“The key issue for us is what happens to asset prices from here,” he said.
“Developers will periodically get into trouble, but creditors generally don’t lose significant amounts unless the underlying asset values fall substantially. At the moment, asset values have declined somewhat, but they haven’t collapsed.
“If that changes and the decline in asset prices gathers momentum, that is when we would become much more concerned.”
Against this backdrop, the Schroders Australian Equities team believes investors should remain focused on fundamental value rather than chasing the strongest-performing themes in the market.
Conlon said the combination of elevated valuations, potentially unsustainable economic support and growing financial market leverage meant this was not an environment for investors to become complacent.
“Valuations are pretty full, and this is not the time to be a hero in equity markets,” he said.
“We think investors need to be patient, think about earnings through the cycle and avoid financial leverage.
“The opportunities are likely to come from areas where the market is extrapolating short-term weakness too far, rather than simply following the strongest narratives in the market.”
