Insights

• Rate cuts expectations are firming. Recent months have seen some mixed economic data but we are seeing clearer guidance from central banks. Major central banks are on track to start their cutting cycles in June which will further support risk assets.
• Moving to a risk-on strategy. We continue to put our cash to work and move to a risk-on stance with a overweight position in global equities, fixed income and real assets (real estate, infrastructure). The US remains our favourite equity market, supported by the prospect of Fed rate cuts, resilient growth and rapid tech innovation.

A favourable backdrop for investment returns

In recent months, debate has shifted away from ‘recession risks’ towards a ‘soft landing’ or even the possibility of ‘no landing’ in the US; inflation has remained on a mild downward trend; and China’s increased stimulus is reducing downside risks both domestically and globally. The US election does not materially change this outlook as it remains a 2H 2024 story, and either continuity under a Democratic President or expected tax cuts under the Republicans could support risk appetite. We therefore see opportunities to put cash to work, and we recently adopted more of a risk-on bias by moving global equities, real assets, and fixed income to mildly overweight.

We continue to prefer the US market, as US earnings and margin resilience, its innovative tech sector and North America’s Re-industrialisation all provide support. This should also continue to provide support for the US dollar. While strong employment conditions in Australia should underpin consumption, high prices for the ASX 20 will mean investors will need to look beyond large-caps for returns. However, the favourable investment environment goes beyond equities. Bond yields remain elevated, and we continue to believe these should be locked in. There was some volatility in bond markets earlier this year as rate cut expectations were pushed out, but they are now in line with ours. We continue to expect rate cuts and falling real yields to bring down bond yield in coming months.

Of course, risks remain in our complex world, but as we have seen, markets are happy to take some uncertainty in their stride as long as the earnings and rate fundamentals remain constructive. We agree with this attitude and believe risks should be managed rather than keep investors away from the market. We believe our investment priorities find the right balance between exploiting the opportunities while focusing on quality and limiting exposure to areas where risks are mispriced (e.g., unlisted commercial real-estate, growth private markets or lower-rated credit).

What’s not to like?

We are underweight cash in our tactical asset allocation and are overweight in both bonds and equities, so we have a clear risk-on strategy. But that doesn’t mean that we are indiscriminate. Across our portfolio we continue to focus on quality. In the bond market, this is principally because credit spreads are too tight to compensate even for a small pick-up in defaults. In equities, we think the cyclical and structural forces continue to support the winners. We also expect a broadening out of performance in asset classes that have lagged (Real Estate, Infrastructure and developed market small-cap equities).

Q2 2024 asset allocation update

We continue our recent trend of putting cash to work to increase our real assets (REITs and listed infrastructure), global equity, and fixed asset allocation. We move to a neutral position in Australian equities. See our asset class views for more (page 2). Expect market narratives to shift rapidly so prepare for shorter cycles. A volatile macroeconomic environment demands vigilance.

Figure 1: Q2 2024 Asset Allocation – Tactical Tilts

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Morgans Chief Economist Michael Knox uses the Chicago Fed National Activity Indicator to model the US economy and explain why there is no incoming US Recession.

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Following the Federal Reserve's latest two-day monetary policy meeting, Morgans Chief Economist Michael Knox says, "yes the FED rates will fall, but only so far."

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Following the RBA's recent decision to hold interest rates, RBA Governor Michelle Bullock said, "where we are now is where we need to be." Chief Economist Michael Knox gives his comments on this saying that the RBA are giving us stability for the near future.

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• Australian corporates again shrugged another reporting test, navigating slowing demand and higher interest rates to post respectable half-year results in February.
• The market’s surge since late 2023, pushing prices to narrow discounts, appears a bigger hurdle to 2024 upside for the ASX20 leaders than earnings or economic fundamentals.
• We explore key themes including: 1) resurgent activity in mid/small caps including M&A; 2) politicisation of supermarket profits; 3) a resilient high-end consumer; and 4) better-than-feared A-REIT results.
• Our best ideas from reporting season include: RMD, NXT, TWE and QBE. Tactical small cap opportunities include: UNI, HLO, AVH, AHL, HCW and AIM.

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February results snapshot and 2024 outlook

Overall, February results provided another important signpost that the health of Australian listed companies remains in good shape. Large-cap stocks missing expectations did remain slightly elevated, reflecting a softer economy. However, this trend, along with a pickup in dividend payout ratios, did improve on August lows, offering comfort that Australian corporates are in robust shape.

Earnings expectations for FY24 actually ratcheted 0.5% higher led by the Banks, Healthcare and Retail. This suggests ongoing conservatism in market forecasts, offering some margin of safety against surging valuations. While plenty of companies did miss expectations, price reactions across the market were positively skewed reflecting a sense that results were largely better-than-feared.

We’re not calling the start of another bull market but do see plenty of reasons to be optimistic in 2024. A likely reduction in interest rates, cooling inflation and plenty of dry powder should be broadly supportive for equities. While there will be some bumps along the way, barring an economic collapse, we think the next 12 months will be kind to investors.

However, discounts to consensus price targets among the market leaders have narrowed significantly. In fact Morgans analysts retain an Add on only four out of the ASX20 large-caps we cover (COL, CSL, S32, WDS). This narrows the path for returns in 2024. We think the best opportunities lie among smaller caps and those positively leveraged to declining interest rates and stickier inflation (A-REITs, small growth and cyclicals).

Solid earnings not enough to sustain large cap valuations

The market’s 12% rally from November to January provided resistance against rewarding larger companies at February results. The ASX 20 large-caps had a sluggish February, easing 0.4%, as heavyweights BHP, WDS, CSL, TLS and WOW fell between 5-9%.

Results were mostly inline but we think a tepid growth outlook (Banks), political risk (Supermarkets) and above-average valuations (ex-Resources) contributed to these stocks’ inability to find another gear

Small-cap resurgence takes shape

Small/mid-cap growth and cyclicals were the bigger story in February, providing a higher proportion of results beating expectations, with a higher-than-average number positively surprising on margins and revenue. Earnings forecasts also held up well in key cyclical segments.

Notably, cyclicals (Retailers, Industrials) represent a larger proportion of the small cap index than for large-caps. So, if the slowdown proves to be milder than anticipated and earnings hold, valuations provide plenty of support here.

We expect plenty of ongoing opportunities in small-caps as the segment continues to re-base. Fresh small-cap opportunities being called out by Morgans analysts include Helloworld, NextDC and Universal Stores.

M&A tailwinds in place

M&A activity has returned with some vigour with ABC, BLD, CSR, APM, AWC, AND, SLC, and AVG having received recent interest.

Activity looks set to accelerate on belief in a turn in the interest rate cycle combined with plentiful cashed-up buyers (particularly private equity and super funds) seeking acquisitive growth as an alternative to sluggish organic growth.

Morgans analysts nominate 24 companies with takeover appeal including Judo Bank, Dalrymple Bay Infrastructure, Tyro Payments, Pilbara Minerals and AI Media.

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Our best ideas are those that we think offer the highest risk-adjusted returns over a 12-month timeframe supported by a higher-than-average level of confidence. They are our most preferred sector exposures.

Additions: This month we add Pilbara Minerals (ASX:PLS), Universal Store (ASX:UNI), Beacon Lighting (ASX:BLX) and Avita Medical (ASX:AVH).

Removals: This month we remove Macquarie Group (ASX:MQG), Aristocrat Leisure (ASX:ALL), Lovisa (ASX:LOV), A2 Milk (ASX:A2M), Corporate Travel (ASX:CTD), Transurban (ASX:TCL), Qantas (ASX:QAN) and Tourism Holdings (ASX:THL).

Large cap best ideas

Treasury Wine Estates (ASX:TWE)

It may take some time for the market to digest TWE’s acquisition of Paso Robles luxury wine business, DAOU Vineyards (DAOU) for US$900m (A$1.4bn) given it required a large capital raising. The acquisition is in line with TWE’s premiumisation and growth strategy and will strengthen a key gap in Treasury Americas (TA) portfolio. Importantly, DAOU has generated solid earnings growth and is a high margin business. It consequently allowed TWE to upgrade its margins targets. While not without risk given the size of this transaction, if TWE delivers on its investment case, there is material upside to our valuation. The key near-term share price catalyst is if China removes the tariffs on Australian wine imports.

CSL Limited (ASX:CSL)

While shares have struggled of late, we continue to view CSL as a key portfolio holding and sector pick, offering double-digit recovery in earnings growth as plasma collections increase, new products get approved and influenza vaccine uptake increases around ongoing concerns about respiratory viruses, with shares trading at 25x, a substantial discount (20%) to its long-term average.

ResMed Inc (ASX:RMD)

While weight loss drugs have grabbed headlines and investor attention, we see these products having little impact on the large, underserved sleep disorder breathing market, and do not view them as category killers. Although quarters are likely to remain volatile, nothing changes our view that the company remains well placed and uniquely positioned as it builds a patient-centric, connected-care digital platform that addresses the main pinch points across the healthcare value chain.

QBE Insurance Group (ASX:QBE)

With strong rate increases still flowing through QBE's insurance book, and further cost-out benefits to come, we expect QBE's earnings profile to improve strongly over the next few years. The stock also has a robust balance sheet and remains relatively inexpensive overall trading on 8x FY24F PE.

Mineral Resources (ASX:MIN)

MIN is a founder-led business and top-tier miner and crusher that has grown consistently despite barely issuing a share over the last decade. Also helping our investment view is that MIN’s diversification leaves it far more capable of tolerating volatility in lithium markets than its peers. We see MIN’s lithium / iron ore market exposures as an ideal combination to benefit from the China gradual recover. We also see MIN as well placed to grow into its valuation, even if we see unexpected metal price volatility, given the magnitude of organic growth in the pipeline.

South32 (ASX:S32)

S32 has transformed its portfolio by divesting South African thermal coal and acquiring an interest in Chile copper, substantially boosting group earnings quality, as well as S32's risk and ESG profile. Unlike its peers amongst ASX-listed large-cap miners, S32 is not exposed to iron ore. Instead offering a highly diversified portfolio of base metals and metallurgical coal (with most of these metals enjoying solid price strength). We see attractive long-term value potential in S32 from de-risking of its growth portfolio, the potential for further portfolio changes, and an earnings-linked dividend policy.

Pilbara Minerals (ASX:PLS) - New addition

We view PLS as a fundamentally strong and globally significant hard-rock lithium miner. The company has successfully executed on ramping up the expansion of Pilgangoora, while progressing plans to expand output (P680 and P1000). Supported by a strong balance sheet, with net cash at ~A$2.1bn at the end of December, PLS’ expansion plans remain uniquely undeterred by the significant weakness in lithium prices. For PLS, the best form of defence against lithium prices is to stay on the attack, with its medium-term plans to continue expanding its production aimed primarily at building greater economies of scale and a more defensive margin.

Woodside Energy (ASX:WDS)

A tier 1 upstream oil and gas operator with high-quality earnings that we see as likely to continue pursuing an opportunistic acquisition strategy. WDS’s share price has been under pressure in recent months from a combination of oil price volatility and approval issues at Scarborough, its key offshore growth project. With both of those factors now having moderated, with the pullback in oil prices moderating and work at Scarborough back underway, we see now as a good time to add to positions. Increasing our conviction in our call is the progress WDS is making through the current capex phase, while maintaining a healthy balance sheet and healthy dividend profile. WDS still has to address long-term issues in its fundamentals (such as declining production from key projects NWS/Pluto), but will still generate substantial high-quality earnings for years to come.

Morgans clients can download our full list of Best Ideas, including our mid-cap and small-cap key stock picks.