The Australian market has recovered from its March/April sell-off to sit around 1% from its February (all-time) highs.
Apart from its proximity to all-time highs, it is interesting to note that the Australian market has performed well over the past year (14% total return). This is despite FY25 earnings growth looking set to come in at a decidedly lacklustre -1%.
Of course, markets look forward and consensus expectations for FY26 are stronger at 6%, although FY26 estimates have been edging lower in recent months.
No Earnings Growth, No Problem?
Market earnings growth has actually been lacklustre for the last three years (FY23-FY25), despite strong market performance over this period (10% pa).
This disconnect between earnings and performance has seen the market PE increase from 16.7x to 18.4x over the last year. This compares to the 5- and 10-year average of 16.7x and 16.2x respectively.
Looking at the sector drivers of the market’s PE expansion shows a disproportionate influence from the banks, with the bank sector PE expanding from 14.9 to 19.1 over the past 3 years and trading at a 38% premium to its ten-year average (see figure 4). As with the market overall, the expansion of bank sector multiples has come at a time of relatively lacklustre earnings growth.
The information technology sector, while much smaller (around 2 % of the index) has seen the most dramatic PE expansion of the major sectors. While the IT re-rate has been dramatic, the majority of sectors (ex resources) and the majority of large cap stocks are trading at a premium to their 10-year average valuation levels. One notable exception is healthcare, which has been weighed down in particular by the CSL de-rate. In terms of the resource sector, energy is trading below its 10-year average, while the materials sector (mostly mining) is trading in line with its 10-year average.
The Australian Equities Superannuation Flow Show
The resource sector (ex gold) has been lacklustre in terms of both earnings and share price performance over the last few years. This has weighed on aggregate market earnings growth. However, it hasn’t really dampened market performance much. Flows have shifted to the “market ex-resources,” where earnings momentum has been better (albeit far from spectacular) resulting in PE expansion across many key stocks and major sectors. The market ex-resources now trades on 21.1x expected earnings, versus a five year average of 18.7x and a 10-year average of 17x. It would seem the relentless flows of domestic superannuation have to go somewhere. With the resources earnings outlook looking weak, investment flows have funnelled into large cap industrials, pushing up valuations in the process.
Bond Yield Decoupling
The local market’s aggregate PE expansion is interesting, given that in contrast with recent bull market cycles it hasn’t been driven by falling bond yields. Bond yields are flat to higher over the last one-to-three years, and are above rather than below their five and 10-year averages. As a result, the “equity risk premium” is quite compressed, which we feel is another somewhat cautionary signal.
Monetary policy cycle is supportive
On the positive side, the prospect of lower cash rates has likely aided the market over the past year. The cash rate has been cut from 4.35% to 3.85% this year and an additional 75bp of policy easing is priced by the interest rate markets over the coming year. This is likely increasing the markets conviction on a FY26 and FY27 earnings recovery, although we expect it to likely be relatively subdued compared to historical standards. Nevertheless, domestic easing cycles have typically been supportive for market performance, so we are aware of the risk of being too cautious on market prospects over the next 12 months purely on the basis of valuation.
Global Stocks Still Dragging the Local Market Along for the Ride
Global equity market performance (and valuation trends) is also a key consideration when thinking about the local market outlook. The Australian market has marginally underperformed global equities over the past year, with the A$ contributing to underperformance at the margin.
While Australia is still underperforming on a 12-month basis, we are tracking in line with global equities this calendar year, as US exceptionalism appears to be fading.
The generally positive uptrend in global stocks over the last year (indeed much of the last three years) has provided a performance tailwind for the local market, notwithstanding our relative underperformance. We have some degree of caution around the pace of the rebound in US/global equites, given the significant ongoing policy uncertainty flowing from the US. Australia is unlikely to be resilient to a global correction, given our relatively full valuations on an absolute and relative basis.
Mixed signals for Australian Equities but staying neutral for now
Stepping back and looking at the medium-term global picture, we retain a broadly neutral stance on global and domestic equities. Central banks are mostly in easing, not tightening mode, and we don’t see the global economy as headed for recession. This is typically a supportive backdrop when assessing 12 month returns. Full US and Australian valuations temper our enthusiasm, but are not enough alone for us to take an overtly negative stance. The prospect of an undervalued Australian dollar grinding higher over the coming year also cautions against being underweight on the Australian market versus global equities over the next 12 months.
Written by
David Cassidy, Head of Investment Strategy
David is one of Australia’s leading investment strategists.
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