Morningstar outlook: Slowing economy warrants caution, but is the ASX market undervalued?

• Morningstar reckons full impact of monetary policy tightening yet to be felt and will influence private sector consumption
• Investors urged to proceed with caution in near term until a more certain environment emerges, which may take several quarters
• Real estate and financial services sectors screen as most undervalued after selloffs following overseas bank and REIT failures

In the haste to get to the next bull leg, financial markets can sometimes ignore the obvious, according to Morningstar head of equities research Peter Warnes.

In his Australia & New Zealand Equity Market Outlook: Q2 2023 Warnes said as central banks near the end of their respective policy tightening, the focus has already turned to the start of the next easing.

“Investors and their advisers can conveniently pass over the consequences of the tightening which can turn out to be an expensive exercise,” he said.

“The inflationary spiral of the past year sent readings to 40-year highs and in response resulted in the most aggressive monetary policy tightening in decades.

“The repercussions are likely to be significant and recent banking failures are a testament.”

The collapse of banks in the US and Swiss bank Credit Suisse recently elevated fears of another global financial crisis.

“While the current banking problems relate to liquidity and a mismatch of assets and liabilities rather than the capital issues of 2008/09, the sector stress is not over,” Warnes said.

“When hundreds of billions are involved, the unravelling will take months, perhaps much longer, not weeks.”

“So far, not one of the rescue efforts has mentioned an injection of equity.”

Warnes said replacing deposits is not a solution, and is more like a Band-Aid.

“Deposits are a liability on bank balance sheets and while aggressive withdrawals trigger a call to action, it immediately brings into question the quality of the assets,” he said.

Warnes said it is almost certain the banking sector will now focus on supporting balance sheets and tightening credit policies.

“The fallout from the upheaval in the US banking sector and possible contagion risks is a credit contraction, which results in economic activity also contracting,” he said.

“The magnitude of the contraction will ultimately be revealed in subsequent gross domestic product, or GDP, data.”

“The impact on corporate earnings as margins shrink still has a way to go.”
 

Investors proceed with caution in uncertain environment

Warnes said financial instability plus sticky inflation point to the conundrum facing central bank decision-makers over the near term.

“They will be only too aware disruptions to liquidity and credit would likely bring on a recession sooner, although the tightening of credit policies by banks will have a similar impact,” he said.

“Should central bankers hit the pause button, they will be hoping the financial instability issues are transitory and that they do not hang around as inflation has for about two years.”

Warnes said financial markets thrive on certainty, however, at present certainty is a scarce commodity.

He said full impact of monetary policy tightening is yet to be felt and will continue to affect private sector consumption, particularly that of households.

“Corporate earnings will suffer to differing degrees challenging both cash flows and valuations,” he said.

“Caution is recommended in the near term until a more certain environment emerges, which may take several quarters.

“In the meantime, cash is a useful alternative and provides optionality.”

He said companies generating maintainable free cash flow should be favoured.

Growth to slow in 2023 as lag in interest rates hikes takes hold

Warnes noted the RBA’s GDP forecast for 2023 is 1.5%, a halving of that achieved in 2022, and for 2024 also 1.5%.

April was the first pause in interest rates hikes after 10 consecutive months. The cash rate is now 3.6% as the central bank looks to pull sticky inflation  back to its 2-3% target.

Annual inflation peaked at 8.4% over the year in December 2022, before dropping to 7.4% in January and 6.8% February.

Warnes said after increasing the official cash rate at 10 consecutive meetings, the RBA board must be somewhat frustrated with the muted impact on household spending, which is the main driver of economic demand.

“In more normal circumstances, consumption would have buckled,” he said.

“But the savings buffer households built from the fiscal stimulus packages during the pandemic and the rush to lock in fixed-rate mortgage loans at historical lows, thanks to accommodative monetary policy and quantitative easing, have allowed households to continue to spend despite higher interest rates and surging inflation.”

He said household spending, the main driver of economic activity, is finally starting to succumb to rising interest rates, easing house prices, and declining real household incomes.

“Surging cost-of-living expenses, particularly in the non-discretionary sector, is affecting spending habits,” he said.

“Consumer sentiment is near historic lows and is unlikely to rebound meaningfully in the near term.”

Market trades at a small discount but defensives remain expensive

Warnes said a modest stock market correction in March led to Australia and New Zealand stocks being slightly undervalued on average.

As of March 31, 2023, Australian and New Zealand stocks covered by Morningstar were trading at a 5% discount to fair value on average, compared with a 15% discount at the September 2022 low and an average 5% premium over the past 10 years.

About 44% of Australian and New Zealand stocks under Morningstar coverage are either 4- or 5-star rated, which Warnes noted is an historically high proportion.

In comparison, the trailing 10-year average is for 22% of our coverage to be 4- or 5-star rated. He said there is a wide disparity in valuations across the market.

“High-quality stocks with defensive earnings are expensive, while those with less certain near-term outlooks are being heavily penalised by the market,” Warnes said.

Real estate and financial services sectors most undervalued

Warnes said the real estate and financial services sectors screen as most undervalued after selloffs caused by market fears of contagion effects from bank and REIT failures in the US and Europe.

“We acknowledge the risks and further downside to shares is possible, but central banks are moving quickly to address banking issues,” he said.

“We think Australian firms are better positioned and risks are generally more than priced in.”

Warnes said the energy, tech, and communication services sectors also stand out with a high proportion of undervalued stocks.

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