Rudi’s View: 2023 Will Be Different

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In this week's Weekly Insights:

-2023 Will Be Different
-FNArena Market Indicators
-FNArena Talks
-Change In 2023

By Rudi Filapek-Vandyck, Editor FNArena

2023 Will Be Different

Never underestimate financial market's ability (propensity?) to surprise when a majority view forms among investors and the experts that guide them.

Last year was all about the return of price inflation, the decisive response from central bankers and the consequences from both for economies, financial assets and corporate profits.

Judging from the first four weeks of January, the general slogan for 2023 is: And now for something completely different. Those worries I just mentioned, they are so backward-looking.

Instead the new points of general focus are all positives:

-Central bank tightening is nearing its end
-Official interest rates are projected to start falling later in the year
-Inflation and bond yields have peaked, and bonds are back as a valuable risk diversifier in portfolios
-China is re-opening, paving the way for a positive contribution to global growth
-Europe's energy crisis is on course to avoid worst case scenarios
-Economic recessions might be avoided altogether (we'll have slowdowns instead)
-Labour markets, economic data and consumer spending have all been fairly resilient to date
-The same can be said about corporate profits
-(Don't mention the war)

In hindsight, these are all valid catalysts for a risk-on rally, though observation number one is this year's unusually strong start into the new calendar year has taken most forecasters and market watchers by surprise.

I'd even go one step further: there's quite a dose of disbelief around the globe right now, and a number of (let's call them) less-exuberant experts are essentially flat-out rejecting what looks like too many expectations and forecasts that a new bull market is upon us.

One example to underpin my observations this year thus far: late last year UBS strategists Richard Schellbach and Akash Biradar put forward their year-end 2023 target for the local ASX200 index as 7500 on the basis of a pause in RBA tightening and relatively subdued profit growth generally for Australian companies.

Having witnessed the strong upward trend in early 2023, both went back to basics and wondered whether the general context has changed so much so that target needed to be increased?

Their response: Njet! While all of the above are positives, this has now well and truly been priced-in by fast-moving share prices. The current index level, argues UBS, leaves little room for re-rate. The economy is still expected to decelerate through the year ahead, making today's profit forecasts seem bloated, hence a new downgrade cycle won't be too far off.

UBS is sticking with its 7500 target by December. Spoiler: that's where the index is today (give or take).

Corporate Profits & Margins

Incidentally, corporate profits in the US are by now showing negative growth at the EPS level when measured against twelve months ago. Finally, one might say, as it has taken this long for all those projections about too much optimism in analysts' forecasts to show up in actual reported data.

US profits are still relatively resilient though, and this has been part of this year's early market optimism. Now cue Morgan Stanley's Mike Wilson who has been among the loudest, steadfast forecasters about US profit margins being too high, having benefited from covid and lockdowns, and thus a key driver of more weakness as this post-covid process unfolds.

This week, Wilson declared his modeling runs pretty much parallel with what the current quarterly reporting season is revealing. But this is not the end of this process. It has but merely begun. The modeling points to sharper declines in the quarters ahead.

One key factor, which equally applies to profits and forecasts in Australia, is high price inflation which still supports growth at the sales and revenues level (as per current quarterly reports), but now a gap is opening up with negative profit growth. This is the margin decline projected by the Morgan Stanley forward modeling, and expected to only worsen in the coming quarters.

In Australia, analysts have been overall busy with reducing forecasts, but better conditions for banks and insurers, plus better-than-expected market updates from retailers have led to an increase for the average EPS growth forecast this year to 7%, with a smaller gain penciled in for next year (FY24).

That sound you are hearing right now is from disbelieving experts scratching their heads, or from falling off their chairs, rolling over the floor while laughing. (Depending on their mood on the day).

To paraphrase the aforementioned UBS strategists: long-term trend growth in Australia runs at 5.5% per annum. At 7%, the average would beat the long-term average during a time when household budgets are under pressure and GDP growth is projected to slow significantly.

UBS is sticking with 4%. Admittedly, the big swing factor is resources companies, and there are multiple positives that work in Australia's corporate favour this year: input costs are off their highs, transport costs are in decline as global supply chain bottlenecks evaporate and a stronger AUD helps various segments of the local economy with margin repair.

Yet, there remains plenty of room for further twists and turns in this story. Quant analysts at Citi, for example, believe large sections of the Australian market are currently enjoying positive momentum, including the banks and many a retailer, and thus corporate results in February are poised for more upside surprises than downgrades, but momentum is expected to deflate as the year progresses.

Citi thinks many share prices in resources companies have run well ahead of fundamental value as the China re-opening trade continues to feed into general optimism. The sector will still be a source of strong cash flows and attractive dividends, but underlying growth is no longer what it has been throughout the two years past.

Many a general strategist agrees with Citi: the Australian economy looks relatively okay in comparison with developed economies elsewhere (even after the recent improvements in forecasts) and the Australian share market looks poised for another year of relative outperformance (as has been the case in January).

Citi's High Conviction "beats" for the February reporting season include Brickworks ((BKW)), Coles Group ((COL)), Fletcher Building ((FBU)), Goodman Group ((GMG)), Imdex ((IMD)), and ResMed ((RMD)). Its sole High Conviction Sell is Monadelphous ((MND)).

ResMed updated on Friday with a strong quarterly update, which had been generally well-received in Australia, even though everyone noticed higher costs and expenses. In the US, however, the release has triggered an old fashioned shellacking, which sees the shares trading down -7% on the ASX on Monday.

Might there be a deeper message for corporate results in general?

UBS has singled out Goodman Group, Computershare ((CPU)), Nine Entertainment ((NEC)), The Lottery Corporation ((TLC)), Netwealth Group ((NWL)), Star Entertainment ((SGR)), and Medibank Private ((MPL)) for a positive surprise in the upcoming season. Downside risks to consensus forecasts are seen for ASX ((ASX)), Harvey Norman ((HVN)), Insurance Australia Group ((IAG)), and AMP ((AMP)).

UBS is also inclined to expect downside surprises from traditional media companies; think News Corp ((NWS)), but also Seven West Media ((SVW)) and Southern Cross Media ((SXL)), with plenty of potential for upside surprises embedded inside the resources sector, think Evolution Mining ((EVN)) and Newcrest Mining ((NCM)), but also Iluka Resources ((ILU)), Lynas Rare Earths ((LYC)), and SSR Mining ((SSR)).

Analysts at Macquarie have joined Citi's assessment in expecting an upside bias in the February reporting season, but they too keep reservations for what follows next. The key question, Macquarie asks, is whether generally better-than-expected profit reports might go hand-in-hand with downgrades to full-year and next year forecasts/guidances?

So far in the US, reports Macquarie, downgrades have been outnumbering upgrades by a factor of three-to-one. It's not that inflation, higher bond yields and steep tightening have no impact, it's just proven to be a slow and gradual process.

Macquarie sees potential for upside surprises delivered by Iluka Resources, Harvey Norman, JB Hi-Fi, Pilbara Minerals ((PLS)) and The Lottery Corporation. The complicating matter is that all of Iluka, Harvey Norman and JB Hi-Fi are also considered overbought; i.e. share prices are trading well above fair value.

Stocks that may well attract downgrades post results in February (Macquarie positioned well below market consensus) include Seek ((SEK)), Star Entertainment, Woodside Energy ((WDS)), BlueScope Steel ((BSL)), Sonic Healthcare ((SHL)), and Telstra ((TLS)).

Banks & Mortgages

One of the reasons as to why the impact from sharply higher interest rates in Australia looks very much like a modern day sequel of Waiting for Godot resides with the local banks. Back in 2020, the RBA provided the banks with $188bn in extremely cheap financing, which allowed for mortgages priced as low as 2%.

Since then the composition of Australia's mortgage market has changed to 46% fixed from 15% fixed prior. These loans will expire from March onwards, and will be refinanced at a much higher 6% variable rate. The argument those "home owners" have had plenty of time to prepare was undermined on Friday when a financial commentator -on live streaming television- shared a story about a mate who had no idea what was about to happen, and had to be explained the consequences from his mortgage expiring in March.

No, I don't understand it either. Even though we all live and die by it, money and finance remain largely gobbledygook for large swathes of the population. Such stories do not instill a lot of confidence in what may follow next this year.

Another surprising twist stems from a recent report by Barrenjoey chief economist Jo Masters whose research suggests local banks have been rather slow in processing higher yield adjustments for variable rate mortgages, resulting in about only 1.1% of the RBA's 3% in rate rises having been passed on to borrowers.

No, I don't understand this either. But if Masters' research is correct, the average mortgage rate in Australia is still due some serious catch-up. Masters thinks a rise to the tune of 150bp by June, irrespective of further RBA rate increases, should be expected. No wonder, also, why Masters believes this re-adjustment is still in its embryonic stage; there's a whole lot more to follow in the months ahead.

Even without the extra insights from Masters & Co, analysts across the board have largely remained circumspect about the future trajectory for household spending in Australia. They have, of course, lifted their forecasts on stronger-than-expected conditions in December.

Investors too were rather reluctant at first, judging from follow-through share price action that followed positive market updates from companies like JB Hi-Fi and Super Retail ((SUL)) but those share prices have since moved well beyond the initial hesitation. This is part and parcel of how the share market operates, of course, as higher share prices tend to feed into more comfort and optimism.

Similar observations can be made for the banks, and for resources generally.

Analysts Respond Through… Downgrades

The response from analysts has been to start downgrading companies as share prices continue to rise. The past two weeks generated no less than 56 downgrades in individual stock ratings from the seven stockbrokers covered daily by FNArena's Australian Broker Call Report against 17 upgrades only.

Corrected for Ord Minnett's switch to Morningstar from JP Morgan (which generates changes simply because another analyst is in charge), those numbers are 38 downgrades versus 13 upgrades. The trend is representative for what is happening outside of FNArena's core coverage.

An incomplete overview from Monday:

-Accent Group ((AX1)) downgraded to Market-Weight at Wilsons
-Adairs ((ADH)) downgraded to Neutral at Goldman Sachs
-Allkem ((AKE)), IGO ((IGO)), and Pilbara Minerals downgraded to Hold at Jefferies
-Chalice Mining ((CHN)) downgraded to Underperform at Jefferies
-Iluka Resources downgraded to Neutral at JPMorgan
-Mineral Resources ((MIN)) downgraded to Neutral at Jarden and at Goldman Sachs
-Seven Group ((SVW)) downgraded to Neutral at JPMorgan
-Insignia Financial ((IFL)) downgraded to Reduce at CLSA

(These brokers are not monitored  daily by FNArena and some are not even included in Broker Call *extra* updates. I am merely sharing this information to illustrate the going trend after a very positive opening to the new calendar year).

There is no universal agreement in these assessments, but those who have been upgraded include some of last year's laggards, such as bond-proxies Goodman Group, Charter Hall ((CHC)) and Transurban ((TCL)), and dividend payers Telstra and Westpac ((WBC)).

On the other side of the ledger, Fortescue Metals ((FMG)) shares have now rallied from $15 to above $22 and not one analyst has changed its target dramatically from $15-$18. All ratings are currently Sell or an equivalent.

Results In February

All of the above suggests the February results season will be a smorgasbord of pros and cons, short-term versus further-out; and a lot will hinge on investors views and confidence.

As per always, FNArena keeps a close eye on releases and how they impact on broker estimates and views. Currently the Corporate Results Monitor at https://www.fnarena.com/index.php/reporting_season/ is still displaying the 50 results released after the August season last year.

From next week onwards investors can expect regular updates as corporate releases multiply. Paid subscribers have access to all insights and data going back to August 2013.

FNArena Market Indicators

To throw in a few proprietary extras from the FNArena data: Total Buy ratings as at Monday, January 30th from the brokers monitored daily sit at 53% versus 37% in Hold/Neutral ratings and 9.50% in Sell ratings.

Historically, such an abnormally high percentage in Buy ratings suggests bear market conditions, but in the context of the past few years, it can be argued the share market is extremely polarised between winners and losers, and that remains the case today.

Extreme polarisation is equally evident among the Big Four Banks. Once upon a time I used the gap between share prices and price targets as a gauge for local market sentiment and whether the market might be, temporarily or otherwise, running ahead of itself.

Alas, there currently is no such gauge available through the banks. CommBank ((CBA)) shares are trading well above consensus target and shares in National Australia Bank ((NAB)) are right "on target", while the gap for ANZ Bank ((ANZ)) and Westpac shares is still 9.9% and 10.4% respectively.

What the Big Banks are showing today is the gap between the two poles in the market, even inside the same sector, can be quite extreme.

FNArena Talks

Last year I was asked by the Australian Investors Association (AIA) to nominate my favourite stock for 2023. I chose IDP Education ((IEL)), back then trading around $28 (which has become $30-plus since).

That video can be accessed via the FNArena website:

https://www.fnarena.com/index.php/fnarena-talks/2023/01/25/rudis-favourite-for-2023/

Change In 2023

A decision was made to separate expert's Conviction Calls from Weekly Insights this year.

I am sure regular readers have appreciated the combination of the two in one email (or one subsequent story on the website) over the years past, but I think we are improving on our service by dividing them into separate stories this year.

So stay tuned, because the next Conviction Calls story is yet to be written… soon! (There'll be plenty in it too).

If you missed the first one for the year: https://www.fnarena.com/index.php/2023/01/19/rudis-view-telix-telstra-treasury-wine-more/

(This story was written on Monday, 30 January, 2023. It was published on the day in the form of an email to paying subscribers, and again on Wednesday as a story on the website. This is a change from prior years when Weekly Insights would be re-published on the Thursday each week).

In addition, since FNArena runs a Model Portfolio based upon my research on All-Weather Performers it is more than likely that stocks mentioned are included in this Model Portfolio. For all questions about this: info@fnarena.com or via the direct messaging system on the website).

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