Insights

• Market risks have escalated and serve as a reminder that ‘accidents’ do happen when central banks hike interest rates aggressively. Portfolios need a new investment playbook and be agile to change in this new market regime of stubborn inflation and elevated volatility.
• This quarter we take a cautious tilt: overweight cash, underweight developed market (DM) stocks and neutral fixed interest/Australian equities. But we are ready to seize opportunities as macro damage gets priced in.

The consequences of rising interest rates

Cracks in the financial system appear as the lagged effects from a rapid succession of interest rates expose some vulnerabilities. However, unlike previous episodes of financial distress, this time, regulators appear to be on the front foot responding decisively with emergency liquidity to prevent broader contagion.

These measures give the troubled global banking system some breathing space, but it’s too early to say if there won’t be more casualties.

There are reasons for cautious optimism and a major banking crisis on par with the Global Financial Crisis (GFC) can be avoided. Unlike in 2007, there does not appear to be large credit losses hidden in opaque instruments on bank balance sheets. Post-GFC reforms mean that large global banks have more robust capital and liquidity buffers.

Risk presents opportunity, and we see a path for investors to succeed in the new regime. Investing in the energy transition, Australian/Emerging Market equities with a value/quality bias and investment grade credit offer the best risk/return profile for a market fretting about what is to come.

Inflation battle likely to take a lower priority for now

With central banks committed to restoring financial stability, the battle to contain inflation is likely to take a back seat in the short term. However, the focus could return just as quickly if regulators and central banks manage to restore confidence.

This has implications for long-duration assets which have seen some valuation relief since the onset of the banking troubles in March. Strategically speaking, we think the market could prove to be short-sighted in ignoring the persistence of inflation.

Nonetheless, in a slowing economic backdrop that sees growth fall and central banks turn less hawkish, a quality oriented fixed income portfolio could play an important role for returns and diversification. This will be especially true if stock/bond correlations turn negative again.

Seeking shelter in emerging economies

Markets have focused on the mayhem in the developed world. Under the radar has been confirmation that the economic restart in China from Covid restrictions is encouraging.

In addition, China’s monetary policy is supportive as the country has low inflation compared with DM. This should benefit Emerging Market (EM) assets. As a result, we keep our relative preference for EM over DM stocks (US/Europe).

Key changes to our asset allocation settings

This quarter we take a cautious tilt: overweight cash, underweight developed market (DM) equities and neutral Australian equities. This is because we don’t believe the market has fully discounted the risk to earnings from a global slowdown.

We take a more constructive view on Australian equities supported by higher commodity prices and strong employment conditions which should see the Australian equity market outperform global peers.

Figure 1: Morgans recommended asset allocation settings

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How much superannuation is enough? It’s a common question and one many Australians ask when thinking about the type of retirement they want to plan for.

Labor’s proposed “Better Targeted Superannuation Concessions”

The Federal Government recently posed this question to the Australian public, throwing out a figure of $3 million. The Government is concerned there are a number of individuals who have superannuation balances well over this threshold who are receiving attractive tax concessions. Hence their proposal to introduce a tax on earnings where fund balances exceed $3 million.

Treasury has released a fact sheet on how the tax on earnings may apply, however, we are still yet to see the consultation paper which will then lead to legislation being drafted.

Here’s what we know so far

1. Legislation is due to take effect from 1 July 2025.
2. If a person’s Total Superannuation Balance is over the $3 million threshold at the end of the financial year, tax on the excess earnings will apply for that financial year.
3. Tax will be calculated based on the difference between the person’s Total Superannuation Balance (TSB) at the end of the financial year and the start of that financial year.
4. Tax will then apply to the proportion of earnings corresponding to fund balances above $3 million.
5. Amounts drawn down/withdrawals will be added back to the formula. This includes pension payments where the person has a pension account.
6. Concessional contributions less 15% contributions tax will be subtracted from the formula.
7. Negative earnings for the financial year can be carried forward into future years to offset positive earnings, if the fund is still operating.
8. A person who has multiple super funds will be able to elect the fund or funds from which the tax is paid.
9. A person will have the choice of paying the tax from personal funds or from their super fund.
10. It is the intent of the Government to ensure commensurate treatment for defined benefit interests. Further consultation in this regard is still being conducted.

What are our concerns?

There appears to be no allowance for regulated pension payments if a person has a retirement pension. Based on the examples provided in the fact sheet, pension draw downs and lump sum withdrawals are treated the same and added back to total super balance. The law requires pension payments to meet minimum pension requirements so we feel adding pension payments back is unfair and should be addressed.

Unrealised capital gains are also included in the total super balance calculations. This has been a very contentious issue since the fact sheet was released. Whether the government listens to feedback remains to be seen.

The $3 million cap will not be indexed so this law will capture far more people in the future than stated. Interestingly, if you consider the effective date is in 2 years’ time, the actual present value of the cap in today’s dollars is around $2.6 million depending on the discount rate you use.

It really is important for individuals to not make any rash decisions at this stage whilst detail is scant. The consultation period may bring some changes or different rules within the proposed policy so let’s wait and see how this goes before contemplating any action.

Watch the Video

• Our Asset Allocation update – 2023 Outlook details our recommended 17% exposure to international equities for investors with a Balanced risk profile.
• 4Q US earnings were lacklustre overall, with cracks also beginning to show in consumption.
• Several global franchises are trading at 15-25% discounts to consensus estimates of intrinsic value, offering opportunities for long-term, portfolio investors.

US Earnings season macro: Mixed views from 3Q US earnings season

All eyes remain on the Fed: Recent US Economic data has shown inflation to be as resilient as the consumer. Many US CEO’s acknowledge a likely recession in 2023. That outcome is likely to be very much correlated with what the Fed does, and what US banks do in response.

Some US Fed governors have recently addressed hot inflation data in January saying they were concerned, but that they also didn’t want to overreact. The Fed will be closely watching inflation and employment before their next meeting on March 21-22.

US 4Q earnings were underwhelming overall, and particularly so for tech companies with Apple reporting a rare miss. Companies beating analyst earnings estimates was well below the long-term average as some steep earnings misses reflect the sting of sticky inflation and rising rates.

S&P500 companies are forecast to report a 4.6% yearly drop in earnings, marking their first earnings decline since late 2020 (Covid).

Resilient consumption generated better than expected results for big box retailers Target and Walmart, however cracks are also beginning to show.

Home Depot is concerned consumers are becoming less resilient to the economy noting “some deceleration in certain products and categories, which was more pronounced in the 4Q.” Lowe’s meanwhile, warned that they were preparing for a “more cautious consumer” this year.

Beware unintended consequences: Recent concerns in the global banking sector raise the question of whether they reflect the beginning of a systemic crisis or are just more isolated issues. Credit Suisse was widely seen as the weakest link among Europe’s large banks, but it is not the only bank that has struggled with weak profitability in recent years.

Moreover, it was the third “one-off” problem in a few months, following the UK’s gilt market crisis in September and the US regional bank failures early March, so it would be premature to assume there will be no other problems coming down the road.

Managing risk: We have been concerned about the risk of unintended consequences from the fastest pace of interest rate increases in modern history. The impact of higher rates on the financial sector comes through with a lag and when interest rates move up so sharply it shouldn’t be a surprise if financial strain manifests.

We continue to advocate exposure to the largest, highest quality global franchises, where many will use economic weakness to grow market share and consolidate their leading positions. Many are now offering clear long-term value.

International shares bearing the brunt of macro uncertainty

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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.

New additions this month: Endeavour Group (ASX:EDV), Ventia Services Group Ltd (ASX:VNT), Tourism Holdings (ASX:THL) and Universal Store (ASX:UNI).

Removals: Jumbo Interactive (ASX:JIN) and Dominos Pizza (ASX:DMP).

Large cap best ideas

Commonwealth Bank (ASX:CBA)

The second largest stock on the ASX by market capitalisation. We view CBA as the highest quality bank and a core portfolio holding for the long term, but the trade-off is it is the most expensive on key valuation metrics (including the lowest dividend yield). Amongst the major banks, CBA has the highest return on equity, lowest cost of equity (reflecting asset and funding mix), and strongest technology. It is currently benefitting from the sugar hit of both the rising rate environment and relatively benign credit environment.

Westpac Banking Corp (ASX:WBC)

We view WBC as having the greatest potential for return on equity improvement amongst the major banks if its business transformation initiatives prove successful. The sources of this improvement include improved loan origination and processing capability, cost reductions (including from divestments and cost-out), rapid leverage to higher rates environment, and reduced regulatory credit risk intensity of non-home loan book. Yield including franking is attractive for income-oriented investors, while the ROE improvement should deliver share price growth.

Endeavour Group (ASX:EDV) - New Addition

We believe the share price weakness over the past six months on the back of an uncertain regulatory environment (eg, potential introduction of cashless gaming cards in NSW) has shifted the balance of risks to the upside with EDV’s underlying business remaining strong. The company possesses a broad network of retail liquor stores/hotel venues, well-known brands (eg, Dan Murphy’s and BWS) and dominant market positions.

Wesfarmers (ASX:WES)

WES possesses one of the highest quality retail portfolios in Australia with strong brands including Bunnings, Kmart and Officeworks. The company is run by a highly regarded management team and the balance sheet is healthy. We believe WES’s businesses, which have a strong focus on value, remain well-placed for growth despite softening macro-economic conditions.

CSL Limited (ASX:CSL)

A key portfolio holding and key sector pick, we believe CSL is poised to break-out this year, a COVID exit trade, 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 offering good value trading around its long term forward multiple of ~30x.

Treasury Wine Estates (ASX:TWE)

TWE owns much loved iconic wine brands, the jewel in the crown being Penfolds. We rate its management team highly. The foundations are now in place for TWE to deliver strong earnings growth from the 2H22 over the next few years. Trading at a material discount to our valuation and other luxury brand owners, TWE is a key pick for us.

ResMed Inc (ASX:RMD)

While we expect the next few quarters to be volatile as COVID-related demand for ventilators continues to slow and core sleep apnoea volumes gradually lift, nothing changes our medium/longer term view that the company remains well-placed as it builds a unique, patient-centric, connected-care digital platform that addresses the main pinch points across the healthcare value chain.

Santos (ASX:STO)

The resilience of STO's growth profile and diversified earnings base see it well placed to outperform against the backdrop of a broader sector recovery. While pre-FEED, we see Dorado as likely to provide attractive growth for STO, while its recent acquisition increasing its stake in Darwin LNG has increased our confidence in Barossa's development. PNG growth meanwhile remains a riskier proposition, with the government adamant it will keep a larger share of economic rents while operator Exxon has significantly deferred growth plans across its global portfolio.

Macquarie Group (ASX:MQG)

We continue to like MQG’s exposure to long-term structural growth areas such as infrastructure and renewables. The company also stands to benefit from recent market volatility through its trading businesses, while it continues to gain market share in Australian mortgages.

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 in the sector. We see MIN’s lithium / iron ore market exposures as an ideal combination to benefit from the China re-opening increase in demand during 1H’CY23. 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.

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 9x FY23F PE.

Transurban (ASX:TCL)

TCL owns a pure play portfolio of toll road concession assets located in Melbourne, Sydney, Brisbane, and North America. This provides exposure to regional population and employment growth and urbanisation. Given very high EBITDA margins, earnings are driven by traffic growth (with recovery from COVID) and toll escalation (roughly 70% by at least CPI and approximately one-quarter at a fixed c.4.25% pa). We think TCL will continue to be attractive to investors given its market cap weighting (important for passive index tracking flows), the high quality of its assets, management team, balance sheet, and growth prospects.

Telstra (ASX:TLS)

After a major turnaround, TLS has emerged in good shape with strong earnings momentum and a strong balance sheet. In late CY22 shareholders vote on Telstra's legal restructure, which opens the door for value to be released. TLS currently trades on ~7x EV/EBITDA. However some of TLS’s high quality long life assets like InfraCo are worth substantially more, in our view. We don’t think this is in the price so see it as value generating for TLS shareholders. This, free option, combined with likely reputational damage to its closest peer, following a major cybersecurity incident, means TLS looks well placed for the year ahead.

Qantas Airways (ASX:QAN)

QAN is now our preferred pick out of our travel stocks under coverage given it has the most near-term earnings momentum. Looking across travel companies globally, airlines are now in the sweet spot given demand is massively exceeding supply. QAN is trading at a material discount compared to pre-COVID multiples, despite having structurally higher earnings, a much stronger balance sheet, a better domestic market position, a higher returning International business and more diversification (stronger Loyalty/Freight earnings). The strong pent-up demand to travel post-COVID should result in a healthy demand environment for some time, underpinning further EBITDA growth over FY24/25. QAN’s balance sheet strength positions it extremely well for its upcoming EBIT-accretive fleet reinvestment and further capital management initiatives. There is also likely upside to our forecasts and consensus if QAN achieves its FY24 strategic targets.

Aristocrat Leisure (ASX:ALL)

We have three key reasons for being positive on ALL. They are: (1) long-term organic growth potential. ALL is better capitalised than many of its competitors and has what we regard as a strong platform to continue investment in design and development in both its land-based gaming and digital businesses; (2) strong cash conversion and ROCE. ALL is a capital-light business despite its ongoing investment in Gaming Operations capex and working capital. It has a high level of cash conversion and ROCE; and (3) strong platform for investment. ALL has funding capacity for organic and inorganic investment in online RMG, even after the recent buyback. Its current available liquidity is $3.8bn.

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.

Seek (ASX:SEK)

Of the classifieds players, we continue to see SEEK as the one with the most relative upside, a view that’s based on the sustained listings growth we’ve seen over the period. The tailwinds that have driven elevated job ads (~210k currently, broadly flat on the robust pcp) and strong FY22 result appear to still remain in place, i.e. subdued migration, candidate scarcity and the drive for greater employee flexibility. With businesses looking to grow headcount in the coming months and job mobility at historically high levels according to the RBA, we see these favourable operating conditions driving increased reliance on SEEK’s products.

Xero (ASX:XRO)

XRO is a high quality cash generative business with impressive customer advocacy and duration. Over the last 12 months rising interest rates and competition have made things harder for Xero. However, we see the current short-term weakness as a rare opportunity to buy a high quality global growth company at a discount to the life time value of its current customer base.

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

• We think investors can take comfort from an overall resilient earnings outlook, and that the conservatism which has been built into market expectations since the pandemic appears to remain in place, providing a margin of safety.
• While aggregate EPS revisions were in line with the August reporting season, large caps well outperformed small caps. Large caps registered the highest proportion of beats in 7 years (41%) while small caps disappointed far more than usual with 32% missing.
• Our best ideas from reporting season include Endeavour Group Ltd (ASX:EDV), Wesfarmers Ltd (ASX:WES), QBE Insurance Group Ltd (ASX:QBE), CSL Limited (ASX:CSL), Qantas Airways Limited (ASX:QAN), Ventia Services Group Ltd (ASX:VNT), Tourism Holdings Ltd (ASX:THL) and Lovisa (ASX:LOV).

Watch

In a holding pattern

Investor concern around the collapse of earnings expectations again proved to be premature as resilient trading conditions continue. The median industrial FY23 EPS revision was -1.2% and most results (59%) fell within a 5% range.

While there are early indications that higher interest rates and inflation are starting to bite (Supermarkets, Automotive, Housing and Housing-related Retailers), volumes and better pricing (Packaging, Insurers, Banks, market-leading Retailers) have been enough to quell the risks for now.

As we noted in our preview, we don’t disagree that higher interest rates signify lower earnings growth but is the market right to be worried about a collapse in earnings expectations?

We don’t think so, but the May ‘confession’ season is shaping up to be a pivotal period to confirm our view. The interest rate cycle has further to run and the peak roll-off in fixed rate mortgages won’t hit until 2H 2023.

So confidence around ‘normalised’ earnings may not materialise before FY24, thus doing little to ease investor concerns in the near term. Unsurprisingly, companies are still hesitant to provide guidance, leaving plenty of scope for earnings to surprise in both directions over the next few months.

Winners: market stalwarts and Losers: growth

Winners: Market stalwarts bucked the weaker trend finishing flat against the ASX 200 which fell 2.9% in February. 43% beat consensus expectations; on average, the cohort saw positive revisions to their earnings and margin outlook.

Strong trading conditions (SUL, GMG, QBE, EDV, SHL) and the ability to pass on costs (BXB, EDV, RMD, WOW, TLS) drove outperformance.

Losers: Growth stocks endured a tough reporting season with the cohort down -3.7% to-date. A few notable underperformers include: TPW, ART, DMP, EML, IEL. Growth hasn’t been helped by the reassessment of long-term interest rates which has driven further compression in valuations.

While the macro backdrop remains challenging for valuations, elevated expectations were also reflected in downward revisions to EPS, with FY23-24 forecasts slashed (Page 10).

Beware the second half skew

Notable companies (DHG, AGL, AMC, BBN, ANN, SLC) missed forecasts in February. Still, they maintained their full-year guidance, setting the scene for potential earnings disappointment if operating conditions don’t recover as planned.

Consensus industrial estimates suggest a second half earnings skew (49%:51%) which is curious given the economic backdrop and is at odds with the typical pre-COVID first half skew (56%:44%).

More specifically, 49% of companies are expected to be skewed to 2H, well above the 25% in pre-COVID times. So if post-reporting earnings trends hold, small caps could be again vulnerable at the upcoming May ‘confession’ season.

Tracking management sentiment

We analysed 102 company result transcripts across 23 industries (Page 7). Overall, sentiment leaned negative across all sectors and was most acute in Utilities, Packaging and Building Materials. It’s also notable these sectors saw sentiment fall further from the August results implying conditions are yet to turn around.

Although still striking a cautious tone, Healthcare, Media, Online and Gaming had the highest sentiment readings across the group. Healthcare and Gaming saw a slight improvement in sentiment from the August result.

Morgans clients receive access to detailed market analysis and insights, provided by our award-winning research team. Begin your journey with Morgans today to view the exclusive coverage.

What does the Indexation of the transfer balance cap mean for you?

According to CPI figures released in December it looks likely the Transfer Balance Cap will index to $1.9 million on 1 July 2023. The amount of this next increase is quite unusual as the normal increment is $100,000. However, it is understandable given the high inflationary conditions we are all experiencing.

The $1.9 million will be the new cap that retirees must consider when looking at commencing retirement incomes. Pension balances must be within this cap for the pension account to receive exempt income.

So $200,000 indexation of the transfer balance cap won’t be available to everyone, however.

• If a person had previously used 100% of their cap when it was $1.6 million or $1.7 million, then this latest increase will not apply.
• A person who had previously triggered their cap by commencing a retirement pension will not benefit from the full $200,000 indexation. Any increase will be in proportion to what their outstanding personal cap is. In other words, if a person has not used all their transfer balance cap prior to 1 July 2023 then only a proportion of the $200,000 increase will apply. The level of indexation will depend on the person’s highest ever balance.

For retirees who have not yet triggered any of their cap the good news is they will enjoy the full benefit of the indexation from 1 July 2023.

Suffice to say, the indexation of the transfer balance cap brings further challenges to the already complicated structure of this cap. Best of luck to the Australian Tax Office who has the job of monitoring everyone’s personal cap.

Advisers and their clients will up to 30 June, no doubt, be discussing whether to commence new retirement income streams or wait until the indexation occurs after 1 July, to get the full benefit of the $200,000 increase or part thereof. There will be advantages and disadvantages either way so as always, best to explore both options before deciding.

Also bear in mind, as a result of the increase to the transfer balance cap that other cap –Total Super Balance – will also increase to $1.9 million. This may benefit clients looking at making non-concessional contributions into super and who may currently be ineligible due to their position last 30 June 2022.

Now, just to complicate things even further the contribution caps index in line with Average Weekly Ordinary Times Earnings – or AWOTE – and not CPI. The AWOTE data just released confirms the contribution caps will remain as is from 1 July 2023. They will not index.

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As always, we recommend our clients speak to their Morgans adviser to ensure they understand how these changes may reflect on their own personal circumstances.