August Newsletter

Despite the continuance of a strong lead from US markets, the Australian market was mixed during August with most indices either neutral or showing a small loss. The exceptions were the Consumer Staples Index which was buoyed by Wesfarmers gaining 4.8% and Woolworths gaining 6.2%, and the Financials Index, which continued to enjoy the stellar appreciation of our major banks.

The laggards were again in the resources sector, headed by Energy and Materials, as oil, gas and iron ore prices continued to weaken. This adversely impacted our resource majors such as Woodside, Santos, BHP and RIO and resulted in respective share prices declines of 2.9%, 10.8%, 4.8% and 6.4%.

Looking ahead, the pervasive themes governing our market remain China, commodity prices,
interest rates, the inflation rate and outlook, the US election and US share market.

In considering China, from Australia’s perspective, a key indicator for how well the Chinese
economy is doing is the iron ore price. Traditionally, the iron ore price picks up in late October, as Chinese steel mills replenish stockpiles. This period will be watched closely, as it has obvious
benefits for our major iron ore miners. 

 

A strong Chinese economy also assists in demand for bulk, energy and base metal commodities. All which Australia supplies and, in doing so, contributes to our economic growth.

 

As the following table shows, the past few years have been ones to forget for our energy, bulk and base metal miners, with hefty price falls experienced in all our important export commodities.

The next part of the Australian equation is interest rates. In this regard, the Reserve Bank of Australia (“RBA”) has been very forthright in its commitment to reduce inflation and continues to signal very clearly that rate cuts will only commence once it is certain the inflation genie is back in its bottle. For the RBA, that genie is corked once the inflation rate (“CPI”) is between 2% and 3%. With inflation seemingly stuck around the current level of 3.5%, there is some way to go.

The problem the RBA has in curbing inflation is that the primary tool at its disposal is determining the appropriate interest rate setting. From a record Covid induced low of only 0.10%, as inflation started to grow in early 2022, the RBA commenced its monetary tightening in May 2022. The RBA then rapidly raised rates to the current level of 4.35%, which was reached in December 2023.


As Chart 1 shows, this rapid escalation in the official cash rate had the desired effect and quickly reduced inflation from a high of 8.4% in December 2022 to around 4% by early 2024. The problem the RBA now has is that the next 0.5% reduction in CPI has been very slow to eventuate with inflation remaining stubbornly high at around 3.5%. 


This elevated inflation rate can be attributed to the fiscal actions of our Federal and State
governments. They continue to spend excessively on stimulatory programs which include
facilitating high immigration, which has placed enormous pressure on housing and accommodation, recent energy subsidies and high levels of government funded infrastructure development that distorts the cost and supply of materials and skilled labour. The risk with keeping interest rates high for too long is that high rates will eventually dampen economic activity, often to a point where the economy can slip into recession. In this regard, the June quarter GDP for Australia was a paltry 0.2% and brought the annual growth rate to only 1%.
Australia is dangerously close to the point where the dreaded recession word will become
commonplace within the media.


A cause and consequence of a slowing economy is consumer confidence. An excellent measure of how consumers are doing is new car sales. Chart 2 is a plot of the new car sales comparing 2024 with 2023. Demand for new cars is weakening and is exemplified by incentives starting to be advertised after a three-year hiatus.

Naturally, our politicians are on the defensive as our economic growth weakens and instead of
looking in the mirror are instead attacking the RBA for maintaining a prolonged high-interest rate
setting. This has culminated at the federal level with our Treasurer trying to override the
independence of the RBA and intimidate it through rhetoric to cut rates immediately.


To date, the RBA has not blinked. Given the RBA’s ongoing commentary that it sees high inflation
more detrimental to future economic prosperity than a short-term fall in economic activity, it
appears they are determined to hold the line.


Consequently, until we see a meaningful reduction in the CPI rate from the current 3.5%, aided by a tightening of the purse strings by our state and federal governments, a rate cut should not be expected anytime soon. At the earliest, we now expect March/April next year.


Many European economies are also under economic stress. Germany and the UK, the two largest European economies, are also only growing at around 1%. In the case of the UK, its central bank went early and hard with interest rate rises, successfully bringing inflation back to 2.2%. Consequently, rates have already started easing in the UK and the economic outlook for 2025 is for marginally more positive GDP growth of around 2%.

 

It is a similar story for the United States, where higher interest rates tamed inflation without
hurting the economy excessively. As a result, the US should enjoy its first rate cut later this month, with more rate cuts expected to follow.

The US markets have already been rallying hard on this expectation of an interest rate cut. For a guide on how long this monetary easing impetus will fuel this rally, the following chart (borrowed from fund manager Talaria Capital), provides a historical summary of the performance of US markets post a peak in interest rates in previous cycles.

Referencing this chart, it would appear the US market has made the most of celebrating the start of the rate cutting cycle. However, more often than not, US markets eventually experience a sustained period of weakness when confronted with the reality that a slowing economy has a
detrimental impact on corporate earnings. 

A complicating factor to this analysis is that history also shows that for at least a 4 to 6 week period leading up to the date of the US election (Tuesday, 5 November), the US market at best trades sideways but more often than not weakens.

With the above in mind, we expect a retracement in the US share market leading into November. Any such retracement will likely cause the Australian share market to also weaken. 

Bank Shares

A huge boost to portfolio performance over the past 12 months and the share market in general
has been the significant rally in our major banking shares.

It is fair to say that the major banks have enjoyed a favourable operating environment of late.
Higher interest rates have allowed banks to expand margins, the very strong housing market
resulted in strong mortgage growth and a healthy economy reduced the frequency and size of
failed loans.

However, much of these operational gains appear to have been absorbed by higher operating costs, including significant expenditure on compliance and technology. 

As a result, our major banks have overall reported flat earnings and, with the possible exception of Macquarie, have relatively flat earnings outlooks for 2025. As such, the rally we have seen over the past 12 months has not been fuelled by earnings growth but rather by Price to Earnings (PE) Ratio expansion. For example, instead of the market valuing a share at say 12 times earnings, the market now values the stock at 16 times earnings.

A grand example is CBA. As chart 6 illustrates, CBA is now trading at a record high PE. This is
despite, as Chart 7 shows, having minimal earnings growth over the past 10 years.

A PE re-rating is not necessarily a bad thing. The market will often re-rate a stock and be prepared to pay a higher earnings multiple because of an improved outlook and performance history justifies an added premium. 

But in the case of our major banks, excluding Macquarie, not a lot has changed. There has been no paradigm shift in the way they operate, their market is limited and operating margins have not expanded to a new sustainable level. Coupled with a benign outlook for earnings growth, as
interest rates drop and the economy slows, many of the positives that fuelled the exuberance for bank shares this year could subsequently evaporate. 

So, whilst we love the banks and every portfolio should have some bank shares, we are extremely reluctant to buy bank shares at current levels and would prefer to wait until the banks are trading on more sustainable earnings multiples. 

This also means that now may be an opportune time, particularly if it is tax effective, to take some profits on bank shares off the table. 

In Summary

The month of August may have marked a short term high for the Australian share market. A
confluence of factors are coming together which could mean a period of sideways or  retracement through to mid November. 

We would see this as a buying opportunity for investors with a number of shares outside the index majors already trading on undemanding earnings multiples. 

As always, please do not hesitate to contact our office to discuss any of the themes mentioned in this monthly letter. I take this opportunity to advise that I will be on leave from Wednesday 11th September through to Wednesday 2nd October. 

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Horizon Investement Solutions

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