Australia and New Zealand stocks rallied in the March quarter as waning inflation strengthened the case for rate cuts later in the year. As of March 28, 2024, our Australia and New Zealand coverage trades at a 5% premium to fair value on average, close to the 10-year average and up from a 15% discount at the September 2022 low.

Price to fair value

Interest rate optimism leaves room for some disappointment

The market has surprised on the upside, with equity investors looking through the malaise to the green pasture of lower interest rates. The S&P/ASX 200 benchmark at close to 7,800 is up about 15% from the late October 2023 lows.

On an unweighted average, our coverage trades at about a 5% premium to our fair value estimates, a modest overvaluation, and close to the 10-year average price/fair value of 1.04. The market rally has come despite a slide in the iron ore miners from inflated levels. Rio Tinto (ASX: RIO), BHP (ASX: BHP), and Fortescue (ASX: FMG) are down 9%, 11%, and 13%, respectively, for the year-to-date (April 3), with late 2023 generally a peak for the group.

It’s perhaps surprising the iron ore miners haven’t come off more, given starting valuations and the much larger 27% fall in the iron ore price for the year to date. I don’t think the market put much stock in the USD 140 plus iron ore price at the start of the year. The futures curve anticipates a further, albeit relatively modest, decline from the current price of USD 104 to USD 90 per metric ton in late 2025 and USD 83 in late 2026, still relatively favorable territory.

It’s easy to imagine the iron ore miner dividend party continuing. All it takes is for President Xi to command a bigger return to the stimulus well in China. Prices for base metals, precious metals, and oil have been strengthening recently. But it’s also easy to imagine a worse case after a once-in-a-lifetime boom and the property sector wobbles. I’d caution investors to be cognizant of history. Cyclical commodity prices and mining profits are generally not conducive to the generous and growing dividends of the recent past.

Major bank gains have more than made up for the miners’ pain. For the first time in a while, none of the banks are in 4-star or 5-star territory. National Australia Bank (ASX: NAB) is now 2-star rated, and Commonwealth Bank (ASX: CBA) is approaching 1-star. The market’s increased optimism toward the banks has some merit. Falling inflation is positive as it lessens the risk of central banks going much harder on interest rates. Relatedly, the risks around the mortgage cliff—the shift from low-rate fixed to higherrate variable loans—are so far being managed well.

Immigration is incredibly strong, and the much-anticipated 2023 recession was avoided, both positive for mortgage repayments. Lastly, ongoing housing supply challenges, coupled with strong immigration, bodes well for the value of the banks’ assets.

While we see plenty of tailwinds for the major Australian banks, the market may be too optimistic about interest rates. If inflation rears its head again, some of the optimism could come out of share prices for banks and other recent winners, including consumer cyclicals, REITs, and tech stocks. Geopolitics and global conflicts, China’s stimulus inflating commodities, and an acceleration in deglobalization, such as shifting supply chains to domestic or friendly sources, could be triggers.

The February reporting season was a relatively normal one, stock-specific issues aside. In aggregate, we raised our fair value estimates by 2.3% on average and 71% of our fair value estimate changes were upgrades. We’re seeing optimism in building materials, supported by population growth. Also noteworthy is elevated corporate activity, with nearly 5% of our coverage subject to takeover proposals.

Rate cuts look more likely as economy softens

Economic growth in Australia is flagging. In the final quarter of 2023, gross domestic product increased a meager 0.2% for annual growth of 1.5%. The RBA expects growth to improve in 2024 to reach a 1.8% annual rate by the December quarter. But this is still firmly below the 20-year prepandemic average of 2.8%.

The RBA’s efforts to dampen demand for goods and services are taking the heat out of inflation, with annual Consumer Price Index growth easing to 4.1% in the December quarter 2023 from 5.4% in September. Annual CPI growth was 3.4% in the month of February 2024.

Most of the price pressure continues to stem from services inflation. Softer GDP growth and cooling inflation nudge us closer to rate cuts. While the RBA left the cash rate steady in March, the board made a subtle change to the language in its decision statement.

In February 2024, the board cautioned “a further increase in interest rates cannot be ruled out.” However, this was amended to “the Board is not ruling anything in or out.” The RBA knows markets closely scrutinize these announcements, and changes like this are deliberate.

Our interpretation is that further rate hikes are unlikely in the absence of an unforeseen shock. On current futures pricing, the market expects the first cut in September 2024 and a cumulative 70 basis point easing by June 2025. However, the timing and magnitude of any cuts depends on the data. Recent signs of sticky inflation, particularly in the United States, and strong employment suggest the market could be too optimistic.

Labor market and RBA forecast

Rate cut timing largely hinges on the resilience of the household sector, which accounts for around half of economic activity. Households with meaningful debt are under significant pressure, paying 70% more in mortgage interest in 2023 than in 2022. Compounding this, the RBA expects the unemployment rate to rise to 4.3% by the end of the year from 3.7% in February 2024. Meanwhile, labor market slack should see wage growth cool to 3.7% from 4.2% in December 2023.

The Fair Work Commission’s minimum wage decision for fiscal 2025 is due by June. While we’re unlikely to see an increase as large as last year’s 5.75%, we expect something higher than the pre-covid-19 norm. While only about 20% of Australians are paid award rates, it is much higher in retail. This should further pressure discretionary retail margins, especially given below-trend sales growth.

We don’t think the upcoming fiscal 2025 budget will dramatically improve the consumer outlook. The recent cyclical stocks rally suggests markets are emboldened by potential fiscal support, but the Treasurer is urging Australians not to expect “big cash splashes.” We estimate the much-anticipated stage 3 tax cuts could add 2% to fiscal 2025 household consumption if the windfall is spent. This is supportive but not enough to send the economy off to the races, paling against the AUD 89 billion of JobKeeper payments that fueled the pandemic spending boom. And with no big cash splashes this budget, we think household spending could miss market expectations in fiscal 2025.

Where we see opportunities

The March quarter saw a large divergence between sectors, with those likely to benefit from lower interest rates, such as consumer cyclicals, financials, real estate, and technology, outperforming while basic materials, consumer defensives, healthcare, and utilities struggled. We see most 4- and 5-star-rated opportunities in energy, healthcare, and real estate. Financial services and technology are two of the most overvalued sectors and could come under pressure if interest rates don’t fall as much as the market expects.

Price to fair value by sector

Morningstar Investor subscribers can access the full Q2 outlook report here.

For more on where we see opportunities: