Market euphoria is facing reality this reporting season

It’s always a critical time for the market, as investors scour company presentations and quiz CEOs in hopes of getting a clearer picture of the operating environment. And while this year has started strongly in the stock market, it’s likely that the big themes of 2022 – the lingering impact of interest rate hikes and inflation – will continue to play a big role in 2023.


Spending cliff?: All eyes on the consumer

Throughout 2022, households continued to surprise markets with high spending, despite rapidly rising interest rates and a rise in the cost of living. When will people finally tighten their wallets?

The question is important not only for retailers, but for every industry with direct contact with household finance, including banking, insurance, media and real estate. It also plays a role for the macro economy and interest rates: Household consumption accounts for around half of gross domestic product.

So far in early 2023, updates from several major retailers have been positive. However, official retail sales figures this week showed a 3.9 percent drop in December, the sharpest drop since the COVID-19 pandemic lockdown.

While some questioned the data, the mixed signals in retail underscore uncertainty in the household sector, which bore the brunt of eight surges in interest rates last year. Another Reserve Bank rate hike is widely expected next Tuesday, adding to the pain.

The ASX is up 16 percent since the end of October despite a weaker economic outlook.

The ASX is up 16 percent since the end of October despite a weaker economic outlook. Credit:Louie Douvis

Daniel Moore, portfolio manager at $5 billion fund manager Investors Mutual, says it looks like consumers had a “pretty good Christmas.” But he’s interested in issues like how much of the sales gain is simply due to rising prices, and also whether consumers are “switching” to cheaper brands.

“Due to COVID, most consumers have acted. Are there early signs they are trading down?” Moore says.

UBS strategist Richard Schellbach also this week highlighted the risk that earlier spending may have been brought forward, paving the way for a sharp slowdown later this year if rates bite.

“We have noted that consumer euphoria is now behind us and that a cliff may be approaching, signs of which will be closely watched in companies’ post-New Year trade updates,” Schellbach wrote.


The chairman of the board of the $196 billion Future Fund, Dr. Raphael Arndt, was also particularly wary of consumer-facing companies this week, stressing that the full impact of rate hikes has yet to be felt. “Any type of investment where the underlying business is exposed to the consumer … is something we monitor very closely,” Arndt said.

“Price power” in focus

Another big issue is how companies are responding to soaring raw material and labor costs.

Over the past year, the two largest sectors of the ASX – mining and banks – have benefited from the inflationary environment as commodity prices have soared and interest rate hikes have pushed up bank margins. As a result, the proportion of miners, metals and energy companies in the ASX 200 index rose from 22 percent to 32 percent, according to Morgan Stanley.

White Funds Management chief executive Angus Gluskie says there is a mixed picture on spending as some energy costs start to fall, while the full brunt of labor and other costs is still being felt. Oz Minerals, for example, warned this week of significantly higher costs from its mines, citing much higher electricity prices and “inflationary pressures.”

Overall, though, Gluskie says a combination of higher costs and weak consumer demand means companies face growing “headwinds” during earnings season.

“I think everyone will be hit in one form or another. But what we’re going to look for is evidence of their ability to handle it and be resilient,” he says.

Since inflation spiked over the past year, stock pickers have sought to find companies with “pricing power” — an ability to pass on higher costs without losing market share.

UBS strategist Richard Schellbach says company profit margins should be supported by easing supply chain pressures, energy costs off their peak and recent Australian dollar strength. He also says a sharp rise in migration to Australia should ease some of the pressure on labor costs – the biggest concern of the last earnings season in August.

Pressure on the cost of living is starting to take hold.

Pressure on the cost of living is starting to take hold.Credit:peter braig

But others are more cautious. Investors Mutual’s Moore argues that gaining pricing power could be more difficult this year as liberalizing supply chains means more inventory is available across entire industries, leading to more intense competition. “I think the pricing power might not prove to be as strong in 2023,” says Moore, who has interests in telecom giant Telstra and logistics company Brambles.

Atlas Funds Management’s chief investment officer, Hugh Dive, also believes some of the biggest retailers — Woolworths, Coles and Dan Murphy’s owners Endeavor Group — are struggling to pass on their cost increases.

“They found it more difficult because it’s a competitive market,” he says. In contrast, he says one company that should pass on costs easily is infrastructure giant Transurban, whose tolls are largely indexed to inflation.

Markets are not pricing in a recession

Against this backdrop of high inflation and fragile consumption, the recent rally in stock prices may seem incongruous. Since the beginning of October, the ASX 200 is up about 16 percent as overseas markets have also rallied.

However, some fund managers believe the recent rise has more to do with hopes that US interest rates are nearing a peak than with actual company performance or the economic outlook.

Veteran investor John Abernethy, founder of Clime Asset Management, says a key influencer of stock prices remains the yields on “risk-free” assets – government bonds.

According to Abernethy, Australian five-year government bond yields are still about 4 percentage points below inflation (a negative “real” yield) at around 3.2%. With bond yields so low, the stock market still looks attractive at today’s prices.

“People say it’s overrated. I say well I think it’s a fair value and compared to bonds it’s undervalued,” he says, adding that there’s even been a surge in “nonsense like bitcoin,” which has risen by more than has increased by 40 percent.

Others, however, are more cautious. Future Fund’s Arndt predicted more volatility this week and said the prospect of recessions abroad shouldn’t be discounted. “We think the markets have adjusted quite a bit now, but they’re still not pricing in a major recession and that’s the risk going forward,” Arndt said.


Most economists, including the Reserve Bank of Australia and commercial banks, do not expect a recession in Australia this year.

But Sean Fenton, portfolio manager at Sage Capital, thinks a domestic recession is “more likely than not” and argues that markets are underestimating the upcoming rate hike. “I think there is still more to do [by central banks] and frankly more pain… and that’s not being priced into the revenue,” he says.

Fenton says he likes stocks like healthcare companies CSL, ResMed and Sonic Healthcare, telecoms and the insurance sector. “Even in recessions, there are industries that grow and do well.”

Who is right, the comments underscore the stark contrast between the recent burst of market optimism and the weakening outlook for the real economy.

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Brian Lowry

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