Martin Conlon

Geopolitical tensions, changing market dynamics and a shift in investor sentiment are reshaping equity markets, according to the Schroders Australian equities team, who identified several key themes emerging from the latest reporting season and macroeconomic environment during a recent adviser webinar.

Head of Australian equities, Martin Conlon, said geopolitical uncertainty, commodity price fluctuations and structural changes in market participation are contributing to heightened volatility.

“There are a number of factors creating uncertainty for investors right now, including geopolitical tensions and movements in oil and commodity prices,” he said.

“At the same time, markets have seen passive and quant money dominate over recent years, which means there are fewer fundamental investors willing to stand against volatile share price movements. That can create additional, and sometimes artificial, volatility.”

Despite the challenging backdrop, Conlon urged investors to remain disciplined and focused on the long-term fundamentals of the companies they invest in.

“Panic is never a good sentiment for investment. If investors are thinking about the sustainable earnings of a company and whether they are paying a sensible price for it, they should generally be OK. The key is to remain rational and focus on fundamentals.”

Reporting season highlights mixed sector outcomes

The latest reporting season revealed stark differences in performance across sectors, with small earnings surprises often triggering outsized share price reactions.

In the resources sector, Justin Helliwell, head of research, Australian equities at Schroders, highlighted a strong result from BHP, driven in part by strategic announcements alongside its earnings release.

The company outlined clearer cost targets for iron ore and provided additional detail around its copper growth pipeline, signalling a more proactive approach to capital allocation and operational transparency.

Meanwhile, the healthcare sector experienced significant volatility, particularly among high-growth companies where valuations remain sensitive to even minor earnings disappointments.

Companies like CSL and Cochlear faced sharp share price declines following small revenue or earnings misses, reflecting the market’s reduced tolerance for companies priced for sustained high growth.

“High-multiple stocks are particularly vulnerable when the growth narrative falters, even slightly,” said Australian equities analyst, Sally Warneford.

“The market reaction to small disappointments has been extremely severe.”

However, some healthcare providers, including Ramsay Health Care and Sonic Healthcare, benefited from signs of improving margins following a period of cost pressures linked to wage inflation and post-pandemic activity disruptions.

Banks and housing demand remain resilient

One of the most surprising outcomes from reporting season was the continued strength of Australia’s banking sector, particularly given the higher interest rate environment.

Banks delivered strong results overall, with housing credit growth remaining robust despite concerns that higher rates would slow borrowing.

“It was a pretty solid result from CBA where we’re used to pretty solid results. But whether there was anything there to say, a 20 per cent rise in the CBA share price, it’s a little bit difficult to fathom why,” said Conlon.

“The bank sector is still as strong as housing credit growth is. We’re still seeing five to six per cent compound growth in housing credit in an already highly leveraged Australian economy. The question many investors are asking is where this demand is coming from, and when will it eventually slow.”

Despite expectations that higher interest rates would lead to rising bad debts, Conlon flagged that reporting season showed little evidence of credit deterioration.

Copper demand supported by electrification, but risks remain

In commodities markets, copper continues to attract significant attention due to its central role in electrification, renewable energy and data centre infrastructure.

However, analysts cautioned that while long-term demand growth is positive, current market expectations may be overly optimistic.

“Electrification is clearly a structural tailwind for copper demand,” said Helliwell.

“But when you look at the numbers more closely, demand growth is likely to average around two per cent per year. That’s solid, but not the exponential growth that some market narratives suggest.”

Helliwell also noted that supply dynamics remain critical in determining long-term commodity prices, and new projects could ultimately balance demand growth over time.

Durable businesses favoured more than short-term growth

Across sectors, the consensus was the importance of investing in durable businesses with sustainable earnings, rather than chasing short-term growth or popular narratives.

High-quality companies with strong balance sheets, cash flows and long-term relevance were seen as better positioned in the current environment.

“In uncertain markets, durability matters more than short-term growth,” Conlon said.

“The key question investors should always ask is whether a business will still be strong and relevant in 20 years’ time.”

He added that investors should remain cautious about highly leveraged companies or businesses dependent on optimistic growth assumptions.

“Ultimately, it’s about owning companies with strong balance sheets, sensible valuations and earnings that can stand the test of time.”

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Sebastian Mullins

As global economies chart a course through a new era of government-driven growth, investors must prepare for a landscape defined by both significant opportunity and rising volatility in 2026.

A panel of Schroders Australia’s investment leaders, including Martin Conlon, Sebastian Mullins and Kellie Wood, say the coming year will be one of divergence, where careful stock selection and a tactical approach will be vital, with the Australian market presenting a compelling picture.

Sebastian Mullins, head of multi-asset and fixed income, says that while the world economy continues to expand, the balance of risks has shifted considerably.

“A surge in government spending, shifting politics, and inflationary pressures will provide global markets with both opportunity and instability,” Mr Mullins says.

“We are now seeing a recovery taking hold in Australia, with growth expected to rise to around 2 per cent as household consumption finally takes the baton from government infrastructure spending. This is supported by an improvement in consumer confidence and a remarkably strong job market.”

However, Mullins notes that this positive momentum faces a key constraint.

“The counterbalance is that inflation remains strong, limiting the ability for the Reserve Bank of Australia to cut rates. Investors need to adapt to this new fiscal-driven landscape.”

A primary concern on the global stage is the concentration of market value in US technology stocks. Mr Mullins says soaring valuations and a surge in corporate debt issued to fund AI infrastructure are increasing the risk of a sharp market correction.

“One lingering concern is whether the strong performance in US tech stocks is a sign of an AI bubble,” Mr Mullins says.

“If we were to see a large equity market sell-off, this would impact the wealth effect of wealthy Americans, likely leading to reduced consumption. In this scenario, the stock market may lead the economy as opposed to the other way around.”

Mr Mullins says that while the largest AI players remain highly profitable, the funding environment is changing in a way that introduces new risk.

“Historically, AI investment was made from free cashflow, but companies like Oracle and Meta have started to use debt to fund their expenditure,” Mr Mullins says.

“US investment-grade issuance from AI big tech firms has risen from less than US$40bn per year to more than US$120bn year-to-date. If more debt enters the system, this will likely lead to a bubble that could pop. Any near-term weakness would be driven by a valuation unwind rather than a full-scale bubble collapse.”

Kellie Wood, head of fixed income, says global markets have entered a new regime where fiscal policy, not monetary policy, is steering the economic cycle.

“Globally, easing cycles are underway. US growth has reaccelerated, with momentum clearly stronger than in early 2025,” Ms Wood says.

“We expect the global economy to accelerate in 2026 after a short-term soft patch caused by lingering tariff effects. The potential for upside surprise remains high and US recession risk low.”

Ms Wood identified credit markets as a standout performer in 2025, and she sees ongoing potential, particularly closer to home.

“We see compelling opportunities in the Australian credit market. Ongoing market development has created pockets of value, supported by increasing breadth and depth across sectors. Both domestic and offshore issuers are drawn to the Australian market by its limited execution risk, even for larger transactions.”

The next phase of the cycle will reward active, tactical positioning.

“As we approach 2026, global markets are contending with a complex and evolving macro landscape. The post-COVID recovery has revealed a shift – economic growth cycles are no longer synchronised and divergence is becoming the norm,” Ms Wood says.

“In this new regime, active risk management becomes essential. Structural shifts are creating winners and losers across asset classes and regions.”

Martin Conlon, head of Australian equities, said today’s markets reflect deep structural imbalances created by network economics and rising government deficits.

“This era has created an environment where disequilibrium has become the norm. Traditional economic forces that historically corrected imbalances are proving less effective, creating both risk and opportunity for investors,” Mr Conlon said.

“The markets we’re seeing today are unlike those of the past. Large companies now dominate global networks, generating extraordinary profits with minimal tangible assets or workforce. The rise of AI is shifting competitive dynamics globally, and this is driving new market behaviours and valuations.”

While Australia is influenced by these global trends, Mr Conlon highlights that the local equity landscape is uniquely shaped by three key sectors: mining, financial services, and construction.

“The extraction of raw materials is a small but crucial sector globally, but it is much larger in Australia. Our financial services sector is oversized due to Australia’s appetite for housing debt and its large superannuation system. And as a high-immigration country, construction represents a much larger share of our economy than in almost any other developed market,” Mr Conlon says.

“The fate of these sectors will always have a disproportionate impact on returns for Australian investors.”

In this environment, Mr Conlon says the market remains one of aggressive yet uneven valuations.

 “Often, the companies commanding the highest prices are not the ones with the strongest fundamentals. Short-term earnings growth and hype around sectors like defence, critical minerals, and AI are drawing far more attention than long-term business sustainability,” Mr Conlon says.

“In markets where speed and overreaction are often mistaken for efficiency, careful, considered investing is increasingly proving its worth.”

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Sebastian Mullins

As global markets reach the midpoint of 2025, a complex and uncertain macroeconomic landscape is fuelling volatility fatigue, according to Schroders, in a new outlook released last week.

The outlook suggests that investors are increasingly ignoring the ongoing geopolitical risk, economic volatility, and policy uncertainty, and instead are choosing to look to fundamentals in an environment where stretched valuations, policy divergence, and asset price inflation dominate the narrative.

Global macro: markets muddle through murky fundamentals

Despite headlines dominated by trade tensions, inflation divergence, and geopolitical uncertainty, global markets have shown remarkable resilience. The current rally has occurred largely without excess sentiment or broad participation, pointing instead to a defensive reweighting toward neutral positioning, says Sebastian Mullins, head of multi-asset & fixed income at Schroders.

While ceasefires and tentative trade agreements have eased some short-term concerns, structural issues remain. Sluggish global growth, fiscal stimulus without productivity reform, and an embattled US Federal Reserve all contribute to a highly uncertain outlook. Inflation remains contained for now, but the potential for fiscal-driven yield curve steepening is growing, particularly in the US.

“Markets are no longer reacting sharply to geopolitical developments, they’re fatigued,” said Mr Mullins. “This leaves us uncomfortably neutral across all asset classes, as valuations remained stretched and expected returns remain muted. But the cycle remains intact, albeit uncomfortably slowing.”

Australian macro: short-term strength, long-term questions

In Australia, the macro backdrop remains stable and supportive in the short term. Inflation is moderating towards the Reserve Bank of Australia’s (RBA) target, and growth remains resilient (though private sector activity is weak), despite the RBA holding interest rates this month.

The upcoming August reporting season is anticipated to provide further insights into corporate performance and expectations for the year ahead. However, questions remain about the sustainability of these dynamics.

“Australia, like much of the developed world, is grappling with stagnating productivity growth and GDP per capita,” said Martin Conlon, head of Australian equities.

“Fiscal imbalances are obvious, with governments showing little intention of aligning spending with tax revenues. While equity markets benefit from their relative size and liquidity, bond markets become volatile. We’ve seen the gap between earnings yields and bond yields reach concerning levels – this reflects a market environment where asset prices are increasingly detached from economic reality.

“Asset prices continue to outpace wage growth, leading to increased wealth for asset owners and a widening divide with the rest of the population. The Australian economy is heavily leveraged, with property prices now four times the country’s GDP, raising concerns about affordability, resource misallocation, and long-term growth prospects. Lower interest rates are unlikely to stimulate productive investment, given capacity constraints in sectors like housing and infrastructure, and instead risk fuelling further asset price inflation,” added Mr Conlon.

Fixed income: a positive outlook for 2025

Yield curves are steepening globally, particularly in the US, as inflation approaches central bank targets and fiscal concerns grow. A potential change in leadership at the Federal Reserve could accelerate this trend, embedding a higher term premium in long-dated bonds.

“The Australian fixed income market has benefited from a stable macro environment, with strong demand for new issuance and average deal subscription levels around 3.8 times covered. Execution risk for new issuance remains very low, and the market is still catching up to Euro and US credit spreads. The July interest rate hold, subdued growth, and softening inflation underpin a positive outlook for fixed income performance through year end,” said Kellie Wood, head of fixed income.

Multi-asset: neutral positioning amid uncertainty

The stance in multi-asset is broadly neutral across all asset classes, reflecting stretched valuations and muted expected returns. While the economic cycle is slowing, it remains intact, and the persistent volatility and policy uncertainty make it difficult to take strong directional views. Globally, equity markets have rebounded sharply from earlier lows, with the S&P 500 rising over 25% from April to June despite ongoing geopolitical risks and muted investor sentiment.

“Most investors have only moved to neutral positioning, and excessive gains across asset classes are considered unlikely given the prevailing macro and policy uncertainty. Short-term volatility is expected to persist, and asset allocation decisions are likely to remain cautious, with investors wary of headline-driven moves and stretched valuations,” said Adam Kibble, portfolio manager.

Credit: strong demand for local securities

In Australia, the credit environment is characterised by healthy demand, solid corporate fundamentals, and a favourable technical backdrop. Corporate balance sheets are solid, with robust margins, especially among infrastructure and utility companies, which are favoured for transparent cash flows and low earnings volatility.

Activity in the subordinated corporate space is increasing, with recent hybrid and Tier 2 issuances. Since March, Tier 2 paper has underperformed senior debt, with some spread widening due to supply in late May and early June, but this was largely retraced as supply diminished and geopolitical tensions rose.

While the US credit market is becoming increasingly expensive and susceptible to volatility, Helen Mason, portfolio manager, believes that strong demand for Australian securities is expected to help mitigate some of this risk, especially with a projected decrease in Tier 2 supply in the second half of the year.

“The credit market has recovered, but the outlook is one of caution due to the potential for further market swings and an uncertain policy backdrop. Investors are advised to remain vigilant, as the environment is likely to remain volatile and sensitive to shifts in fiscal and monetary policy,” said Ms Mason.

Australian equities: fundamentals under pressure

Investors face a challenging environment where valuation discipline and a focus on fundamentals are increasingly difficult to maintain amid regulatory and market pressures, according to Mr Conlon.

“The Your Future Your Super regime and the rise of passive investing have redefined ‘risk’ as simply not holding enough of the largest index constituents, such as CBA. This has meant CBA being bought at ever-higher valuations, regardless of its fundamental value, exposing investors to almost certain loss.

“This distortion is not limited to CBA. The market’s obsession with businesses that employ minimal capital and promise rapid economic value creation, with little regard for business duration, is detached from economic reality and history. Companies have become skilled at offsetting current bad news with future optimism.

“The market’s fixation on revenue growth and momentum leaves opportunities in more mundane sectors, such as energy and materials, largely ignored, except for gold. We see abundant opportunity in these less fashionable corners of the market,” said Mr Conlon.

“We remain committed to a disciplined, risk-adjusted approach to value creation, even as market forces and policy settings make this increasingly uncomfortable. We will continue to seek out opportunities where the crowd is not looking, and to resist the pressure to follow the herd into overvalued territory,” added Mr Conlon.

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Martin Conlon

Confusion reigns. As the apparent stability of past decades gives way to a more unpredictable behaviour, investors are attempting to run for safety but seem a little unsure where to run. Following the crowd seems irresistible yet may not be logical.

If you ever get close to a human
And human behaviour
Be ready, be ready to get confused
There’s definitely, definitely, definitely no logic
To human behaviour
But yet so, yet so irresistible
– Björk

Logic did not play a great part in the global events of the past month. Whether financial market reactions to those events was any more logical is debatable. Attempting to unwind the myriad of interdependencies emanating from a multi-decade globalisation process in a week or two was probably never going to go swimmingly. It didn’t.

The initial premise seems to involve the US somehow being ‘ripped off’. The logic behind this premise is not immediately visible. The US runs a significant trade deficit with the rest of the world, partly because it consumes a lot more than it produces (the polar opposite of China), and partly because the world needs to balance (if other countries want to depress currencies or artificially support certain sectors, someone needs to do the opposite).

Even ignoring the fanciful idea that trade balances for most countries should somehow be near zero in a globalised world or the problems in reshoring production when wages are vastly higher than in production centric economies, as a revenue measure it totally ignores the massive differences in profitability of different import and export types.

The US tends to export extremely high margin products and services (e.g. Microsoft, Google, Visa, Mastercard, Nvidia, Apple) and import very low margin products from China. These high margins, plus an expectation from investors they will continue to grow faster than the rest of the world, explain much of the premium multiples US equities command versus the rest of the world and the total dominance of global market capitalisation.

When it comes to the ‘ripped off’ bit, it seems the rest of the world would probably have better arguments, particularly given the lack of local tax paid on profits. Additionally, the nature of western production means almost nothing is comprised of purely domestically produced components.

It is entirely unrealistic to bring 100% of production of most end products back to a single country. As the chart below illustrates, Chinese imports to the US are comprised significantly of intermediate products, supporting production rather than consumption.

The longer term economic impact of US actions on the rest of world obviously remains uncertain. Regardless of whether tariffs are almost entirely rolled back, the impact of increasing global tension and the US taking a more adversarial approach to international relations seems likely to be longer lasting.

Source: Apollo

Trade deficits aside, the budget deficits afflicting the US and most of the western world are probably the real issue when it comes to sustainability.

While DOGE suffered from the same lack of realism as tariffs when it comes to correcting decades of accumulated bureaucracy and inefficiency in weeks, it is tougher to argue with the logic. Wasteful government spending is strangling economies everywhere, yet plans to spend less and collect more in taxes are absent, meaning government debt is spiralling everywhere. Asking foreigners to fund ever increasing government largesse will always be more palatable than asking your own citizens, unfortunately, most of the foreigners are in the same boat. As Australians were dragged to the voting booth to choose between two parties competing on unfunded handouts, bipartisan housing policies which fundamentally ignore the demand side of the housing affordability crisis and don’t touch the issues of an overly complex and poorly structured tax system, it is tough to throw stones. We are on the same path and the road sign doesn’t read ‘sustainable’.

Source: UBS, ABS, Australian Government, State Governments, Macrobond, RBA

Source: UBS, ABS, Australian Government, State Governments, Macrobond, RBA

Equity markets have reacted fairly simplistically. US equity market returns for 2025 to date tell the story. Purely domestic equals good, cross border equals bad. Amazingly, even as bonds reflect concerns over some of the aforementioned deficit dynamics and the wisdom of having so much of the world’s investment capital centred in the US, overall equity market performance since ‘liberation day’ has remained solid. The domestic equity market has risen as domestic defensives, banks and gold compensate for losses elsewhere. Falling share prices have been concentrated in mining and energy.

We are struggling with the logic behind these moves, but human behaviour (even if it is in the form of computer coded portfolio rules) sets share prices. As always, economists are preoccupied by increased odds of US recession as measured by their beloved ‘GDP’. Recession fears mean sell cyclicals and buy defensives.

The focus on China as the primary target of US acrimony and the expectation of declining US demand as tariffs flow through to higher US prices and then back into lower Chinese production may not be illogical should significant and sustained tariffs actually eventuate, however, the US is a far less important cog in the global commodity demand wheel than in products in which it pays a disproportionately higher price than the rest of the world (e.g. pharmaceuticals).

The nature of commodities means the US pays largely the same price as other consumers globally (adjusted for on-costs such as shipping) and is most certainly not being ‘ripped off’. While commodity prices will always oscillate through time, particularly as ever more financial capital enters constrained physical markets, we continue to see low cost mining assets as durable and attractively priced businesses relative to the assorted avenues into which investors are seeking to run and hide at present. As has become ever more the case in recent years, starting valuations appear meaningless, it is only the direction of the next move which matters. We live in the era of the increment.

Source: Finviz (1 May)

When it comes to avenues for seeking safety, gold has been front and centre of recent times, heading in exactly the opposite direction to most other commodities. In typical financial market fashion, when tariff threats and tensions most need the financial plumbing to assist in keeping the economy flowing, investors are most inclined to do the reverse. Buying gold, after all, is the financial equivalent of hiding your money under the bed. There is no yield and speculative capital gain or loss is the only source of return.

March quarter World Gold Council data indicates jewellery demand for the quarter fell some 20% from a year ago, while central bank purchases fell a similar amount. Good old ETF demand exploded as investors chased all-time high prices, both in absolute price terms and relative to most other benchmarks (e.g. barrels of oil, other commodity prices).

As a commodity in which there is no fundamental basis for formulating a long-run price, we have always struggled. Its price is purely driven by human behaviour and that behaviour is unpredictable. Nevertheless, our theory that other commodities should provide similar inflation protection if investors are worried about the debauchment of fiat money has proven entirely incorrect in the short-term and the winners write the history. Analyst enthusiasm for gold stocks is growing with share prices and they are applauding the cash generation of gold stocks (a function of extremely high gold prices and denominated in exactly the fiat money they are seeking to avoid by buying gold).

Source: Refinitiv

In illustrating the gap between tariff theory and reality and why we’d be surprised if some tariff levels are sustained, Alcoa is probably a useful example. Of the more than 70 million tonnes of aluminium consumed annually, the US represents a little over 4m. As the Alcoa chart below indicates, more than 80% of US consumption is imported. High cost refineries/smelters in the US have been closed through time (Alcoa closed Point Comfort in Texas in 2019) and sites are more likely to be re-purposed as data centres than restart given the low-cost power which is crucial for smelters can be far more lucratively used than in alumina refining and aluminium smelting and the US doesn’t have the good quality bauxite needed to make the stuff.

Canada has low-cost hydro powered smelters which already supply most of US demand. China, despite being by far the biggest consumer (more than 40m tonnes) is not a low cost producer and occupies much of the high end of the alumina/aluminium cost curve. China successfully suppresses profits able to be earned by others, but they don’t make much profit themselves.

Tariff announcements caused the aluminium price to plummet (the good old recession arguments again), whilst the Midwest premium (the price paid by US buyers including tariffs) rose to reflect much of the tariff impact.

Whilst there is still a net cost of tariffs to producers such as Alcoa as the Midwest premium doesn’t fully reflect tariff cost, the vast majority of tariff impact is simply to push up aluminium prices in the US. This will eventually flow through to prices of all goods using it. The only way any production could return to the US is if the US chooses to permanently force domestic customers to pay a higher price for a commodity in which the US is not cost competitive.

As an investor, betting on permanent tariff protection as the justification for an investment in the billions in a location without low cost raw materials, construction costs or power seems unlikely to be a persuasive case. Logic suggests industry may be better supported by providing access to the commodity at the same prices the rest of the world pays and focus on making money turning it into Boeing planes and high value products. The $2bn fall in Alcoa’s market value during the month suggests panic was a more popular strategy than logic. The decline in market value for South32 was almost identical.

Source: Alcoa Q125 Investor Presentation

Where investors saw opportunity during April was the once in a lifetime opportunity to pick up some CBA at close to all-time high prices and a raft of defensive stocks and technology stocks with earnings yields at or below the bond yield, many vastly below. CBA, Wesfarmers, Coles, Telstra, Woolworths, Transurban, Goodman Group, NAB, ASX, The Lottery Corp, Stockland, Mirvac, Dexus, GPT, Vicinity Centres, Scentre Group, IAG and Suncorp all saw gains of more than 5%. Pro Medicus, Life 360, Technology One, REA Group, Car Group, Wisetech Global, Xero, Block, Netwealth and HUB24 all bettered the 5% mark also.

Seeing a theme here? Avoiding earnings risk at all costs continues to vastly overwhelm valuation risk. Numpties like me who perceive some risk in paying $24bn for the $200m of revenue generated by Pro Medicus (more than the value of Alcoa and South32 put together) are receiving regular reminders of the stupidity of placing any emphasis on valuation. While CBA may be the poster child evidencing the diminishing importance of fundamental analysis in setting equity market pricing, the cohort of stocks suggesting business valuation is an antediluvian pastime is broad.

Market Outlook

As Björk’s 1993 lyrics suggest, we should be ready to be confused by human behaviour. We’d confess to not finding all of the current behaviour irresistible. Frustration would better capture our emotions in watching the CBA valuation climb past 25 times earnings and towards 4 times book value despite anaemic/non-existent growth and negligible bad debts. The bifurcation in valuations which pervades both sectors within the equity market and the ‘haves’ and have-nots’ when it comes to perceived growth has proven vastly more persistent than we could have imagined. Short periods of reversion have been followed rapid rebounds, renewing the confidence of momentum driven investors. On Björk’s “Be ready, be ready to get confused” bit, we’ve got that nailed.

Source: Macquarie (7 April 2025)

Source: Macquarie (7 April 2025)

Maintaining discipline isn’t easy. Regularly adjusting your long-term gold price to convince yourself that your gold stocks are still good value or amending the revenue multiple applied to a technology stock and comparing it to a bunch of others that have tripled as a purported valuation measure might create the illusion of discipline, yet the line between this and losing all discipline is fine. As global tensions rise and long years of seemingly unsustainable levels of government spending show signs of testing the patience of bond investors, it seem to us a dangerous time to shed discipline. Embracing sensible valuations and conservative financial leverage has been uncomfortable territory for much of the past decade. Human behaviour can change.

By Martin Conlon, head of Australian equities

The post Human behaviour appeared first on AdviserVoice.

Claire Smith

Schroders head of Australian equities, Martin Conlon, has warned against paying too much for assets given an underlying disconnect between share prices and the real economy and says equity prices will remain vulnerable next year as the cost-of-living climbs in Australia.

The Australian equity market is currently witnessing divergent trajectories between the financial economy and the real economy. While asset prices continued to rise in 2024, this growth is not reflected in the real economy, leading to concerns about the sustainability of this trend, according to Mr Conlon.

“Equity markets continue to ride the wave of money which is supporting asset prices but not living standards. The difference between fundamentals and multiples mean company valuations are like corks on the ocean, driven by sentiment and news. Whether and when we revert to fundamentals is impossible to predict, but waves do tend to break eventually,” Mr Conlon said.   

One of the main drivers of this disconnect is the Australian housing market. “The housing market continues to be a central issue, with rising costs contributing to inflation and cost of living pressures. The high demand for housing has led to a surge in prices, which is not sustainable in the long run. As interest rates rise and affordability decline, there is a risk that the housing bubble could burst,” Mr Conlon said.

Adding to risks for equities is that the strong run over the past year in Australia has been driven by an expansion in earnings multiples rather than earnings growth. While share prices have increased and earnings multiples expanded, they may not be supported by corresponding increases in company profits, leading to concerns about overvaluation.

“Underlying this multiple expansion were substantial gains in the very large financials sector and enormous gains in the smaller, but increasingly large technology sector. While the property sector also saw multiples elevate, one could substitute data centres, as the heavy lifting was done by Goodman Group.

“Multiples for materials, energy and consumer staples remained fairly moribund, with materials and energy retaining the mantle as the cheapest sectors. While ‘average’ price-earnings (P/E) ratios are now substantially above long-term averages, these averages are flattered by the high benchmark weightings and earnings dominance of materials and financials,” he said.

Another risk factor to consider, Mr Conlon said, is Australia’s reliance on China. If the Chinese economy slows, there is a risk that demand for Australian exports could decline. This could have a negative impact on the Australian equity market.

“Subdued sentiment on China and poor affordability and economics in housing construction are creating the preconditions for depressed multiples for Australian shares and jeopardising future returns. In an environment in which investors become ever more attuned to chasing popular themes at incredibly rich valuations, it is perhaps understandable that most investors are happier running with the crowd than feeling lonely,” Mr Conlon said.

“However, there can be no hiding from China’s importance as a demand source for Australia’s exports, but as a production rather than consumption-led economy, economic weakness is usually met through stimulating additional production. Without incremental domestic demand to absorb this production, China is increasingly becoming an intermediary between raw materials and export markets.

Mr Conlon also sees problems for Australian lithium producers.

“Lithium spodumene prices are languishing at not much above US$700/t and lithium carbonate around US$10,000/t, well below what investors, including Rio Tinto in its Arcadium Lithium acquisition, expect as the long-term price. While wanting to be more optimistic on the prospects for the lithium sector, our enthusiasm is tempered by valuations which still reflect long run pricing well above the costs of most players.”

Despite these challenges, there are also opportunities for investors in the Australian equity market, Mr Conlon said.

“There are plenty of companies available for sale at sensible multiples if one is prepared to see attraction in the more mundane characteristics of durability and profitability rather than alluring growth prospects and a large Total Addressable Market.”

“Many of the most appealing investments from our perspective are centred in real economy businesses across the materials and energy sectors,” adds Conlon.

“Subdued sentiment on China and poor affordability and economics in housing construction are creating the preconditions for depressed multiples and attractive future returns.”

Schroders’ outlook also delves into the private equity landscape, where it is anticipating a more favourable environment in 2025.

Claire Smith, head of private assets sales with Schroders, predicts that 2025 will be a year of opportunity.

“While 2024 has been a subdued year for dealmaking, we are beginning to see promising green shoots that presage brighter times ahead in 2025.”

“Private equity, especially that in which Schroders invests, shows signs of resilience and growth. The interplay between falling interest rates and easing inflation sets the stage for improved multiples.  Exit values in the global market seem to be stabilising, too, with a recent uptick in sponsor-to-sponsor exits.”

“As we look to the year ahead, many of the dynamics that have put downward pressure on multiples should subside or reverse. Namely, falling rates and cost pressures should promote higher multiples as borrowing costs go down and cashflows improve,” said Ms Smith.

Ms Smith said Schroders prefers the small and middle markets where valuations are attractive.

“There remains a significant valuation discount for small to mid-sized buyouts when compared to their larger peers, suggesting a difference in perceived value within the market,” she said.

 “These markets are diversifying, tend to perform well during volatility, and the law of large numbers makes it inherently easier to generate meaningful multiples on small companies than on large companies.

“Importantly, too, operating in the small and middle markets means we’re not reliant on a still frozen IPO market for exits. Rather, our exits tend to be into the larger part of the market where a large pile of dry powder remains,” she said.

Smith also flagged Schroders’ preference for investment in “GP-led secondary” funds, a segment of the private equity market where existing investments are rolled into a new fund under the direction of a general partner.

“Sponsors engage in GP-led transactions to enhance the value of a portfolio company by allowing additional time and/or capital for further strategic development. By executing a GP-led transaction, sponsors can adopt a longer-term perspective on a company, effectively extending the holding period of an asset beyond the conventional four to six years.”

“More and more dedicated strategies are beginning to focus on GP led secondaries, and the main issue most will encounter is that the majority of GP-led secondary deal flow is in the small to mid-cap market. Additionally access to these prized assets will often be restricted to existing investors and structured and executed on a proprietary basis.”

And while the election of Donald Trump has stoked volatility, Ms Smith believes Private Equity could stand to benefit.

“Finally with the new Trump administration, there could be more volatility in the market, and our research shows that private equity delivers most of its long term outperformance during more volatile periods.  Private equity has historically outperformed listed markets by 4% per annum, but when you look at times of higher volatility this outperformance increases to 8 per annum%. If we are indeed in for more turbulent times, private equity could be a nice place to hide.”

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Sebastian Mullins

Global and Australian economies and markets are holding up better than was expected just four months ago, according to the Schroders Australia investment team, but that doesn’t mean the good times will last forever.

“The surprise of the past four months is that the Australian economy in general, and businesses in general, have held up better than people expected in the face of higher interest rates. This was particularly the case across the retail sector, where the pointy end of economic slowdown is normally felt as consumers tighten their belts. It really wasn’t as bad as it could have been,” said Martin Conlon, head of Australian equities at Schroders Australia.

Sebastian Mullins, head of multi-asset at Schroders Australia, added that the discussion in the US around what kind of ‘landing’ for the economy and markets was expected has also shifted.

“Now the discussion is around how strong the US economy is and that’s caused our economics team in London to increase their forecast for US growth from a low of 1.3 per cent for this year, up to 2.7 per cent,” Mullins said.

“Rather than having a crash landing or a hard or soft landing we have a reacceleration in the US. It’s almost like when a pilot aborts a landing on an airplane, you have to reaccelerate before you try and land a second time.”

In other global opportunities Mullins pointed to Japan, even though it is in a technical recession.

“We do like that economy because the equity market still looks cheap and there are structural reasons for it to do well,” he said.

“We also like other asset classes like Australian credit. That’s giving a pretty healthy yield for the high quality.” Noting that spreads are high relative to their own history and against global corporate spreads.

However, Conlon said caution is needed around some of the very high valuations for the AI and tech related companies.

“I still believe ‘That it’s different this time’ are some of the most dangerous words in investment and the reality of market valuation levels, particularly in the US market, are high by historic standards and they are very high relative to interest rates,” he said.

With the US representing close to 70 per cent of the global market cap – with approximately 30 to 40 per cent of that market in tech and communications – but only about 18 per cent of global GDP, there are some obvious overexposures for not just the US but all international investors.

“There is a big presumption there that the profit growth of particularly those big technology companies is going to keep on growing, and it’s going to be durable forever. And when the companies underlying that position are, for the most part, global monopolies, I think that can be a sign of complacency. Those numbers and valuations give me a lot of pause for thought,” Conlon says.

But that doesn’t mean that tech and communications, and AI in particularly, aren’t worthy of investment.

“I am a believer that AI is going to do a lot of wonderful stuff. But I think, as I alluded to earlier, the profit projections of where, and how it’s going to change the profit pools of the world, are probably running ahead of what is most likely to happen,” Conlon said.

Mullins concurred, but cautioned against ignoring the Magnificent Seven just on AI valuation concerns.

“Earnings in these stocks have continued to beat expectations because their current business models have been delivering, very little AI earnings can be attributed to current results,” noting they have double the margins and have grown free cash flow twice as fast as the other 493 stocks in the S&P 500.

“While its likely these stocks pull back after a strong rally, it’s premature to call them a bubble,” he said..

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Andrew Fleming

Schroders is excited to announce that Netwealth has added the Schroder Equity Opportunities Fund to its super and investment solution.

The Schroder Equity Opportunities Fund is now available via Macquarie Wrap, HUB 24, mFunds and Netwealth. Lonsec has given Schroder Equity Opportunities Fund an initial rating of Recommended.

Graeme Mather, Head of Distribution says “We are pleased that Schroders have been able to accommodate the strong demand from the market through further platform inclusion.”

Lonsec reports: “Given the nuances of the local market, Lonsec believes the Fund’s ‘all-cap’, benchmark unaware approach can offer improved economic diversification relative to a traditional benchmark aware approach. Furthermore, Lonsec has high regard for the investment team led by Martin Conlon and Andrew Fleming as well as Schroder’s ‘bottom-up’ investment process”^[1]

Schroder Equity Opportunities Fund invests beyond the benchmark for greater breadth, taking insights from Schroders’ Australian Equities team to invest across the full market cap spectrum. At September 2017, the fund has delivered returns of 13% (net of fees) over the preceding 12 months.

Longer term, the Fund has outperformed the S&P/ASX300 index by 3.4% p.a. (net of fees) since its inception almost 10 years ago.

The Schroder Equity Opportunities Fund allows unconstrained investing and avoids the pitfalls of cap-weighted benchmarks without the stock concentration normally associated with ‘high conviction’ portfolios. The team also manages the Schroder Australian Equity Fund, which has held Morningstar’s highest analyst rating for 10 consecutive years, retaining the ‘Gold’ Morningstar Analyst RatingTM^[2] in September 2017. Schroders was also awarded 2017 Fund Manager of the Year in Domestic Equities – Large Caps Category, Australia. Morningstar Awards 2017 (c). Morningstar, Inc. All Rights Reserved.

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[1] The Lonsec Rating (assigned as follows: Schroder Equity Opportunities Fund – 28 September 2017) presented in this document are published by Lonsec Research Pty Ltd ABN 11 151 658 561 AFSL 421445. The Ratings are limited to “General Advice” (as defined in the Corporations Act 2001 (Cth)) and based solely on consideration of the investment merits of the financial products. Past performance information is for illustrative purposes only and is not indicative of future performance. They are not a recommendation to purchase, sell or hold Schroder Investment Management Australia Limited products, and you should seek independent financial advice before investing in these products. The Ratings are subject to change without notice and Lonsec assumes no obligation to update the relevant documents following publication. Lonsec receives a fee from the Fund Manager for researching the products using comprehensive and objective criteria. For further information regarding Lonsec’s Ratings methodology, please refer to our website at:http://www.lonsecresearch.com.au/research-solutions/our-ratings This rating is not to be circulated or distributed and is solely for the information of financial services professionals, such as a financial adviser.

[2] © 2017 Morningstar, Inc. All rights reserved. Neither Morningstar, its affiliates, nor the content providers guarantee the data or content contained herein to be accurate, complete or timely nor will they have any liability for its use or distribution. Any general advice or ‘class service’ have been prepared by Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892) and/or Morningstar Research Ltd, subsidiaries of Morningstar, Inc, without reference to your objectives, financial situation or needs. Refer to our Financial Services Guide (FSG) for more information at www.morningstar.com.au/s/fsg.pdf . You should consider the advice in light of these matters and if applicable, the relevant Product Disclosure Statement before making any decision to invest. Our publications, ratings and products should be viewed as an additional investment resource, not as your sole source of information. Past performance does not necessarily indicate a financial product’s future performance. To obtain advice tailored to your situation, contact a professional financial adviser. Some material is copyright and published under licence from ASX Operations Pty Ltd ACN 004 523 782 (“ASXO”). The Morningstar Analyst Rating for Schroder Australian Equity Fund strategy is ‘Gold’ as at 21 September 2017.

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What didn’t change much was the propensity for the winners to keep winning and the losers to keep losing. These trends continue to confound many of our underlying beliefs in how economies should function, how the businesses comprising the economy make money and how the fundamental value of these businesses should be reflected in equity markets. Probably the main reason we struggle to embrace momentum investing is the powerful tendency of return on capital to revert to the mean rather than to expand perpetually, both within industries and more broadly. Staying ahead of competitors in the very long run is tough. Whilst investors are inclined to capitalize the status quo into perpetuity, physics and basic maths usually work against over-optimism in the longer run. When Daniel Kahneman was asked in a recent interview what he’d eliminate from human nature if he had a magic wand, his answer was “overconfidence”. We’d agree. Entirely unrealistic optimism always pervades the popular wisdom on sustainable levels of economic growth, population growth and asset prices. It will not stop politicians, economists, CEO’s and investors promising and relying on them. It will stop their realisation.

Murphy ’s Law has applied to our stock selection efforts and at times (now!) we feel like we’re making Murphy look like one lucky son of a gun. We cannot blame all our errors on exogenous factors. In trying to understand the root cause of our numerous errors and why ‘mean reversion’ has been notably absent of recent times we must inevitably go back to basics. Capitalism, in order to function properly requires the process of what Joseph Schumpeter described as ‘creative destruction’. The strong thrive and the weak are allowed to fail. A free market facilitates new entrants to challenge the strong and allows bankruptcy to remove the weak. It allows prices to be set by supply and demand rather than by a regulator or government. One of the most crucially important ‘prices’ in the economy is the price of money; interest rates, as the above process works far more effectively when interest rates are kept relatively stable.

As concerns over lack of growth and a need to respond to financial crises have seen interest rates fall to 5000 year lows (a claim proven recently by the Bank of England’s Chief Economist, Andrew Haldane), this process has been largely stymied. The progressively greater distortion of interest rates is gradually overshadowing the process of free market competition as the driver of profits in the economy. As a result, interest rates have also become a hugely disproportionate and correlated driver of all asset markets. An uncomfortable amount of the current global dysfunction seems to us to have its root in pricing money incorrectly. Whether it is the now wildly outsized nature of financial markets relative to the underlying economy or the massive incentive to use financial leverage against any assets offering cashflows exceeding the cost of debt, there is far more evidence of unproductive uses than of companies ‘investing’ for growth.

We struggle to see how 10% swings in the oil price in a couple of days are driven by fundamental changes in supply and demand. In a world of wildly outsized financial assets it is far more likely that incremental pricing is at play, allowing relatively small changes in the massive financial asset pool to inflict wild price swings on the underlying assets. As such, we believe the expectations of many for a low return but stable environment are highly unlikely to be realised.

These principles are also applying at the business level. It would seem anomalous to us if every mining and energy CEO was a blundering fool (they are mostly in TV bidding for AFL rights) whilst every bank, REIT and infrastructure CEO is a genius. Whilst not wanting to rain on their parade, our suspicion is that there are a number in each category, together with a large number in the mediocre category. Versus generations past, we would suggest they take some solace in at least being more handsomely rewarded. Wildly divergent outcomes are being driven primarily by interest rates. Mining and energy businesses are undoubtedly the canaries in the coalmine. Misallocation of capital in China causing excessive capacity addition has flowed back down the chain. Profitability of underlying assets is under enormous pressure and many are struggling for oxygen. Few are yet failing as ludicrously low interest rates allow profitability to almost totally evaporate before creative destruction arises as an option. One then seeks a government subsidy.

The manifestation of capital misallocation as iron ore mines or LNG facilities with insufficient sustainable demand should be seen alongside a similar process in other sectors. August saw a bid for Asciano (+4.4%) finalised by Brookfield Investment Partners. Asciano is a well-managed business unlikely to augment profits under Brookfield ownership. The transaction merely sees the addition of financial leverage, allowing the same profits to support more apparent asset value (debt and equity). Babcock and Brown would be proud. Heightening merger and acquisition activity globally (now back to 2007 levels), particularly in market darling sectors such as healthcare, technology and infrastructure are not indicative of a sudden surfeit of uncovered gems. It is merely an alternative and more expedient method of compressing return on capital than organic capital spend, particularly in sectors with almost no tangible capital anyway. The result will be the same, the time frame perhaps slightly different. The irony in chastising the Chinese for apparently illconceived plans to support an ailing stock market or devalue the currency when manipulation of interest rates and asset markets lies at the heart of almost every Western economy, is hard to ignore. The Chinese do not have a monopoly on capital misallocation.

Outlook

Our views on the way forward are undoubtedly tinged with frustration borne of an obvious failure to anticipate the extent to which interest rate manipulation could both persist and permeate every facet of the global economy. Massive amounts of wealth have been transferred in the process, whilst none has been created. The compression of available returns to those employing both tangible and financial capital has left both profits and asset valuations vulnerable. Although the pricing of many assets may not appear egregious versus prevailing interest rates, these rates are wrong. We continue to exhort companies to shed financial leverage rather than participate in the process of capital misallocation. The escalation in merger and acquisition activity and buybacks together with ever increasing dominance of earnings momentum as an investment strategy, would suggest our exhortations are falling on deaf ears. Only those already feeling the intense pain of this misallocation (energy and resource stocks) understand of the consequences. As a result, these sectors house the bulk of businesses where valuations reflect a pessimistic view of longer term outcomes, and thus offer good prospective returns. ‘Standing against the wind’ is becoming ever more difficult, reflected in the massive underperformance of any valuation based investment strategy globally. Interest rate sensitive investments are both leading the market higher and insulating from downturns, as the entire investment world embraces an expectation that all mishaps will be met with further monetary accommodation, ensuring the price of excessive leverage (creative destruction) is never paid. In the longer term, we remain of the view that excessive leverage must be unwound. History indicates that periods of strong wealth creation emerge from periods in which interest rates have been set at levels which encourage and reward effort and productivity gain rather than leverage and speculation. For regulators and policymakers that remain doggedly aligned to an approach that falls firmly into the latter category, we’d offer some advice penned by Midnight Oil in ‘Powderworks’, a favourite from my youth:

There’s a shit storm a ‘coming
I feel it coming soon
There’s a time and a place
And a moment in space
When the fat boys call the tune
There’s a bubble a bouncing
And it’s bouncing my way
There’s two sticks in the powderworks
I think it’s gonna blow today.

By Martin Conlon, Head of Australian Equities, Schroder Investment Management Australia

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