Insights

• Morgans research analysts re-set their sector views, strategies and best ideas as dynamic forces continue to challenge markets.
• Our approach in equities currently favours stocks with compelling risk/reward profiles among quality cyclicals, small-cap growth stocks and A-REITs.
• Preferred equity sectors include staples, healthcare, financials, retail, travel, resources and energy.

Result season snapshot and 2024 outlook

February results again showed that Australian listed companies remain in good 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 rising share prices.

The market’s surprise rally since late 2023 appears a bigger hurdle to further market upside than earnings or economic fundamentals look to be. The implied risk premium (earnings yield) and dividend yield premiums in equities has compressed to historical lows, manifesting in narrow discounts to consensus price targets among the market leaders (ASX20) and narrowing the path for further upside.

So we’re not calling the start of another bull market, but we do think there are plenty of reasons to be optimistic. A likely reduction in interest rates later in the year, cooling inflation and plenty of dry powder should offer solid tailwinds for equities. Below the ASX20, we think the best opportunities lie among smaller caps and those positively leveraged to declining interest rates and stickier inflation, including select cyclicals, small-cap growth and A-REITs.

Small/mid-cap growth and cyclical stocks were the big story in February. They provided 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 economic slowdown proves to be milder than anticipated and earnings hold, then 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.

In this note, Morgans sector analysts have upgraded their ASX sector ratings on Consumer Discretionary to Overweight (from Neutral) and Agriculture to Neutral (from Underweight). Downgrades have been applied to sector ratings on Telco to Strongly Underweight (from Underweight) and the Banks to Underweight (from Neutral).

ASX sector & size returns: February trading demonstrated the ongoing rotation away from expensive defensives and into growth and cyclical stocks (Small-caps, Retail, IT, Industrials) as risk appetite recovers

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• 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.

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.